TAX REFORM ACT of 1986: PUBLIC LAW 99-514 Lp267t

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TAX REFORM ACT OF 1986: PUBLIC LAW 99-514 lP267T

On October 22, 1986, President Reagan signed into law H.R. 3838, the Tax Refom Act of 1986, P.L. 99-514. This tax revision measure establishes two tax rate brackets of 15 and 28 percent for individuals and a corporate income tax rate of 34 percent, to take effect in tax year 1988. For tax year 1987 there will be a blend of old and new rates. This Info Pack includes a summary of the new law and provides information on the followipg topics:

General provision individuals...... p. 1 Treatment of real second homes...... p. 10 Retirement savings provisions and pensions (includes IRAs , 401 (k)s, vesting, and distribution). .. . .p. 14 Corporate tax change overview...... ^. 25

The enclosed CRS report on the effects of the new tax law (IB87010) lists other reports on special topics.

Please note that the IRS will be issuing new regulations on many of the law's provisions. We cannot answer in detail specific questions regarding an individual's tax liability; one may need to consult with a nearby IKS office, or seek the advice of an attorney or accountant.

CRS does not have copies of P.L. 99-514 for distribution. Many Federal depository libraries and other libraries with collections of legal material have copies of the law available for reference use. The full text of the law may be purchased from:

Superintendent of Documents U.S. Government Printing Office Washington, D.C. 20402

Tax Refom Act of 1986: P.L. 99-514 Stock no.: 822-009-00274-6 Price: $24 (prepaid)

Additional information on the effects of the new tax law, primarily in newspapers and periodicals, can be found in many local libraries through the use of indexes such as the Readers' Guide to Periodical Literature and the Wall Street Journal Index.

Members of Congress desiring additional information may call CKS at 287-5 700.

Congressional Reference Division

Source: BNA Daily Report for Executives, Oct. 23, 1986, pp. G748

COMPARISON OF CURRENT LAW AND TAX REFORM ACT OF 1986 Individual Taxes

Provision Current Law New bw

I Individual Tax Rate I I5 rate brackets from l l percent to 50 per- Two rate brackets set at 15 and 28 percent. cent. indexed indexed, effective 1988; 15-percent bracket phased out for high income taxpayers creating top marginal rate of 33 percent: five rate brackets in 1987 set at I l percent. I5 percent. 28 percent. 35 percent, and 38.5 percent

Capital Gains Rate I I 60-percent exclusion, 20-percent effective Exclusion repealed. effective for taxable years after kc. 31. 1986: the maximum rate on long-term gains is 28 percent in 1987

Personal Exemptions 5 1.080. indexed 5 1.900 in 1987. Sl.950 in 1988. 52.000 in 1989, indexed thereafter. phased out for upper income taxpayers

Zero Bracket -\mount New standard deductton Single S3.000 (53.750 if blind or elderly; 54.500 if blind and elderly) Joittr 55.000 (55.600 if blind or elderly: 56.200 if blind and elderly) Hrads of household 54,400 (S5.150 if blind or elderly; 55.900 if bhnd and elderly)

Ditidend Exclusiop ! s I OO/SZOOexclusion Exclusion repealed income Averaging Lower marginal rate of 40 percent of the ex- Repealed cess over the average of the prior 3 years

Two-Earner Deduction Allowed (53.000 maximum) Repealed

Earned lncome Credit Allowed (S55O maximum) IIncreased (S800 maximum) Fringe Benefits Healrh I Not taxed Not taxed. with 25-percent deduction for self-employed Group-rrrnc lib insurance. Irgol services. Not taxed S50.000 exclusion for life continued; legal drpendrnr care. rducarion assistancr. services, education assistance extended wn pooling through 1987; 55.000 cap on dependent care; van pooling not extended I Replacement LStrmplr~~~ncenr Taxed if ACI over 5 12.000 (S18.000 if Taxed married) I Workrrs' c.o~~tprn.rurion No1 taxed Not taxed I Reproduced by the Library of Congress, Congressional Research Service with permission of copyright claimant.

1 G - 8 (No. 205) TAXATION AND ACCOUNTING (DER) 10-23-86

COMPARISON OF CURRENT LAW AND TAX REFORM ACT OF 1986 Iadividd Taxes

- Currest Irw New Law

No werall cap I NO overall cap Store and local income. property. and Deductible Sales tax deduction repealed soles taxes Charitable contributions Deductible (non-itemirer deduction expires Deductible for itemirerr. Deduction for non- after 1986) itemizers allowed to expire Morrgoge inrtresr Deductible Deductible for principal residences. second homes, with anti-abuse prov~sionlimiting deduction to the basis of the property plus imprwements. student loans. and medical expenses Other interest Personal interest deductible; investment in- No deduction. except for net investment tercrt limited to S 10.000 over investment interest hf edical Expenses Deductible abwe 5 percent of AGI 1 Increase floor to 7.5 percent of AGI Meals and enrertainment expcrues Deductible ( Deductible up to 80 percent Passive. tax shelrer losses Generally, no limit to use of deductions Deductions disallowed against income other than passive income, with exceptions lor rental real esiau and oil and gas ventures: phased in over five years. with special exceptions for real estate tax credits .Vise. Expenses Hobbyfgambling, employe home oftice, Floor of 1 percent of AGI. with full deduc- union dues. etc.. no floor tion for certain other expenses

Retirement Savings 1 IRA limit SLOOO deduction for taxpayers without employer retlremcnt plans. and for joint filers with AGls up to SJ0.000 and singles up to 535.000 Spousal IRA S250, allou for spouses uith no compensation JOlIkl plans 530.000 annual deferred limit 57.000 limlt. indexed beginning in 19811: no IRA offset

Xlinimum Tax Alternative tax set at 20 percent ?I percent rate. adding preferences. including passive losses. tax-exempt interest on newly issued public purpose bonds. untaxed appreciated property contributed to charities

At-Risk Rula Generally not applicable for real atate Extend to real estate. with third-party fb nancing exemption

Tax on trusts and similar arrangements hav- Flat tax of SS percent. dropping to 50 per- ing kneliciarles in more than one genera- cent in I9RLL. Direct transfers would be tion below donor taxed. with exception for some grandchildren

Generally taxed at child's marginal rate Generally taxed at parent's marginal rate for child under 14 with esceptlon for first 5 1.000 of incume

Copyright Q 1988 by THE BUREAU OF NAllONAL AFFAIRS, INC., Washington. D.C. 20037 Source : WALL STREG.-J&%-w, August 18, 1986, p .7,8

--- 1 How the Bill Would Simplify 1988 Tax Brackets / I Married Couple Filing Jointly Single Filer PLUSTHIS PLUS THIS PERCENTAGE PERCENTAGE OF AMOUNT OF AMOUNT INCOME , PAY BASE OVER LOWER IhCOME PAY BASE OVER LOWER Fare Under Tax Bill BRACKET TAXOF BRACKET BRACKET TAX OF BRACKET Proposed percentage tax cuts. I I Conference BUI I I Conference Bill by income group INCOME CLASS CONFERENCE BILL I (In thousondd 1987 1988 I Current Law* Current Law* Lees than $10 -55.2 -65.7 $0 $0 3,860 2,610 $10 to $20 -16.4 -22.3 6.250 3.860 $20 to $30 -10.7 -9.8 8.640 5,000 13,520 7,390 18.180 9,660 22.960 12.270 27,960 14,660 33,980 17,050 40,000 20,680 52,050 26,710 68,190 32.730 -2.3 97,280 38,750 $200 and above +11.4 124,330 47.160 184.570 62,850 92,970 NOTE:Inflation adjustments are calculated using the Congressional Budget Office's economic projections, which show inflation of about 5.8% over the next two years. *The current-law includes standard euctians. Under the conference plan. the standard deduction is subtracted fromtaxabbt l~comebefore taxes ueeomputed.

Tax Overhaul Milestones Aug. 5,1982 Sen. Bradley and Rep. Gephardt Introduce their tax overhaul plan. la 25,1984 President Reagan orders the Treasury to study tax overhaul.

Apd 26,1984 Rep. Kemp and Sen. Kasten introduce thek version'of tax overhaul. Nov. 27,1984 Treasury Secretary Donald Regan unveils Treasury I. May 29,1985 President Reagan endorses a new plan, Treasury 11, devised by Treasury - Secretary James Baker and Deputy Treasury Secretary Richard Darman.

Nov. 23,1985 The Ways and Means Committee passes its tax-overhaul bill, which has a top individual tax rate of 38%and takes a bigger whack at business than does the president's plan. Dec 17,1985 After first being blocked by House Republicans, the Ways and Means bid is passed by the House by voice vote.

April 29,1986 Forced to withdraw his own package because it is laden wkh special-interest amendments, Chairman Packwood of the Senate Finance Committee unveils another ply with a top individual tax rate of 27%.

May 7,1986 Senate Finance Committee unanimously approves 27%-rate tax bill. It would kill most tax shelters, curtail individual retirement accounts, and raise business taxes less than the House bill. Top corporate rate would be 332. 24,1986 By a vote of 97-3, the Senate passes the Finance Committee's bill with only , minor changes.

Aug. 16,1986 House-Senate Conference Committee approves compromise bill that sets top individual rate at 28%,corporate top rate at 31%.

@ 1986 Dow Jones & Company. Inc. Reproduced by the Library of Congress, Congressional Research Service with permission of copyright claimant. THE NEW YORK TIMES, MONDAY; AUGUST 18, 1986 d 89 .,r. - The Tax Bill of 1986: ~ro~rekiveSystem Is Kept I

Tax-*-A System to Remain Progressive, Experts Say

*-A. --A- By ROBERT PEAR ers at higher income levels pay larger affecting lower-income working fami- There would still be winners and -*.a UI ~h New YorkTlmcs ' proportions of their incomes in taxes lies - the personal exemption, the losers at every level. People with in- +-WASHINGTON,Aug. 17 - For pea- than people at lower levels. standard deduction and the earned incomes above $200,000 a year who are in- *&with low and moderate incomes, The bill shifts part of the individual come tax credit - "have all been se- volved in limited partnerships and income tax burden to corporations. The ;*e tax bill represents the most impor- verelv eroded bv inflation." other tax shelters mav. exoeriencer *&nt advance in Federal policy in more corporate income tax is generally be- he said, the new tax bill large increises in their tax bills - -'Wan a decade. according to both lib- lleved to be progressively d~stnbuted "does not so much extend the safety net w'OOO a year- But people with ~kfalsand conservatives. because, according to many econo- as repair a hole that has developed similar income from interest and divi- mists, it is indirectly paid by higher-in- v-7-.,,-Moreover, the bill reflects a historic "only dends can look forward to tax cuts of come individuals (whose dividends and since 1978." nebill, he ,,amensus in Congress that there compensates for tax increases on the magnitude. ., . tpodd be less use of the tax code as an capital gains are smaller than they working poor in recent years and re- -mstrument of social policy. would dherwise be). The rise in corpo- turns tax burdens on low-income fami- I Analysk of the 28% Rate _',:At first blush, the new system, with .rate taxes may thus enhance the over- lies to the levels of the late 1970's." all Progressivit~of the tax structure. Despite the fact that families with -.two tax-rate brackets for individuals, The bill, he said, does little or nothing taxable incomes of $50,000 would be "rippears less progressive than the cur- Harvey Galper, an economist at the Brookings Institution, said: "You can't for families so poor that they cu~~entlysubject to the same 28 percent mar- Z-mnt law, which sets 14 rates for people have no income tax liabilities. gical rate as families with $2 million of f.& different income levels. But this as- Just look at the statutory rates. You .. . . income, tax experts said the new sys- -6wsment is superficial and probably have to look at the effective rates pe& pie actually pay on their income. The Families With One Parent tem would be at least as progressive as ''-ng, according to tax experts, who present law. Tax breaks almost lay the new system will be just about current effective rates are not so pro- Single-parent households, a gmup of gressive we can't match them with great concern to social policy experts, excluslvely by the wealthiest taxpay- ;*% progressive as the present one. ers be under the bill, * *."The supposed progressivity of the lower tax rates and a broader base." fare well under the bill. Under present One of the most significant achieve- law, such households must pay more in they said. The broadening of the tax ::cent system is a complete sham," base will generally be greatest for Pea- ,.said Eugene Steuerle, an economist at ments of the new tax bill is to remove taxes than two-parent families with the same income because their standard pie at the highest imome levels be- ,!he Enterprise Institute who about six million low-income house- cause they have taken most, advantage * Pomerly worked in the Treasury's Of- holds from the tax rolls. This was an es- deduction is considerably less (= 390 sential component of the political bar- for single heads of households ' as of Opportunities to avoid taxes under c "dice of Tax Analysis. "The high statu- current law. So they will experience the '.tory rates create a mirage. The new gain that produced a bill cutting tax against $3,540 for manidindividuals rates for people at all income kvels. filing joint returns). greatest increases in tax liabilities, the :&- - code will not be sienificantlv- less experts said. ;p_mgressive." Bill's Changes for the Poor By raising the standard deduction for ,,To be sure, the current rates are single heads of households closer to The bill appears to reduce incentives The bill would eliminate Federal in- for COnstruction and rehabilitation of * graduated and appear highly that for married couples, the new bill -p1togressive.- ~utso many types of in- 'Ome taxes for most working People sigruficantly reduces the difference in housing for low-income families, and pelow the'~vert~level and a signif- Some people are concerned that this come- are excluded from taxation that tax treatment of the two types of fami- .Ue. effective rates people actually pay lcant number Just above the poverty lies. ~orty-eightpercent of all poor may ~ducerent increases that offset are much less progressive than the tax line. A family of four was classified as families are headed by women with no the tax cuts for these families. poor in 1985 if it had cash income of less .rate schedule would suggest. husband present, according to the Cen- Douglas B. Diamond, an economist than $10,989. sus Bureau. at the National Association of Home , . What People Actually Pay Robert L. Greenstein. director of the Center on Budget anpolicy ~rioritie;, Single heads of households, like two- Builders, said that "We expect rent in- - - Census Bureau data show that house- creases averaging well over 10 per- holds with pre-tax incomes of $.%J,OOO or a research and advocacy group, noted parent families, will also benefit from that "Federal tax burdens on working the bill's increase in the ~ersonalex- cent" for lower-income families. Even '..more actually paid, on the average, increases of 5 percent would fully offset -. 18.3 percent of their incomes in Federal poor families have increased dramati- emption for dependents. - , cally in recent years." A family of four the tax savings that the typical low-in- .income taxes in 1984, while those mak- Alicia H. Munnell,senior vice come renter will receive, he said. ing $15,000 to $17,500 paid 6.9 percent. at the poverty level had to pay 10 per- dent of the Federal Reserve Under current law the rate for married cent of its income in payroll and in- Boston, said people would probably Mr. Steuerle, the economic staff L-eimpleswith incomes of $50,000 or more come taxes last year, as against 4 per- consider the tax system fairer after the for the Treasury's 1984 tax ranges from 38 percent to 50 percent on cent in 1978. bill becomes law. If so, she said, "there ~roposal,said the legislation may also ; the last dollar of income. The main reason for the increase in would be less incentive to evade taxes the behavior of homeowners. , Under one commonly used definition, these burdens, Mr. Greenstein said, is and perhaps more acceptance of the "There will be less tendency to mart- I $tax is said to be progressive if taxpay- that three key features of the tax code civic duty to pay taxes." gage your house to the hilt," he said. 1 New York Times, 8/18/86, p. B9 (continued)

: 1. , -3 b ...' "It may once again become profitable withdraw savings 'for personal: cbn- for families to build up equity in homes sumption, purchase of a home or cother rather than borrow against them, be- purposes would be subject to larger cause the effectivetax subsidy given to penalties than under current law. borrowing will be reduced." Frank B. McArdle, a spokesnx%! for Economic Emphasis Seen the Employee Benefit Research 1,wti- tute, a nonpartisan organization, said: l'hi",, he said, is part of a larger pat- "Congress provided tax benefit%lor tern. Under the bill "there will be more these programs to insure that:wle of a tendency for individuals as well as would have retirement income: If fhe businesses to look at the economic ef- Programs are not used for that-Pur- fects of their actions, rather than just Pose, Congress concluded, the ~2- the tax effects," he explained. centives are not working properly-- The bill does not tax employers' con- _ 3 tributions to employee health plans. In addition, he said, the tax' bilbre- The Treasury and the Reagan Admin- fleets Congress's conclusions' &at istration have proposed such levies "there need to be tighter rules to !ns>re several times in the last few Yeam- that pension, health, life insurance and But the bill does tighten the rules for other employee benefit programs- dc pensions and other retirement savings not unduly favor hi&er-paid workefs.' plans to make sure that people use the If a benefit plan unduly favors tfili l$?st , money for the intended Purposes and paid workers, he said, the extmbene do not withhw it early. People who fits would be subject to taxat$s,'; @ 1986 Time Inc. Reproduced by the Library of Congress, Congressional Research Service with permission of copyright claimant. AFTERREFORM: Borrowing The New Math of Managing Your Personal Debts You may lose some prized interest deductions, but the rules will still leave you plenty of borrowing room.

BY DEBRA WlSHlK ENGLANDER

If you are a credit junkie, watch out. The tax reform bill of 1986 has eyes for you-the eyes of a narc staring down a crack dealer. Several of the most important changes: b A gradual elimination for itemizers of tax write-offs for interest payments on personal loans and consumer debt, including credit-card finance charges and loans for cars, vacations and school bills. b A limitation on the number of houses-two-for which you can claim a deduction for mortgage interest. A cap on the amount of interest you can deduct for most home-equity loans. A strict limit on how much you can deduct for interest charges on loans from your broker. b And, most of all, a cut, because of lower tax rates, in the value of interest de- Vpay for almost everything by credit cards. ductions. This will raise the after-tax cost of all borrowing, including that for buy- After reform, I'll cut back. 1may start ing a house. Take, for example, an interest deduction of $1,000. Under current carrying cash when I go shopping. " law, it reduces a togbracket taxpayer's IRS bill by SS00. Next year, with the top --KAREN ROBINSON OF VOORHEES, N.J. rate at 38.5%, his savings will be $385; in

PHOTOGIIAPH BY KEUY / MOONEY OCTOBER 1986 91 6 Borro wina

1988, with him in the 28% bracket, he Tax reform will lei you will save only $280. As a result of the new math, you will borrow against your have to pay closer attention to the after- tax cosr of debt. The basic post-reform house, for example/ principle, according to Timothy Kochis, national director of personal financial to buy a car or planning at Deloitte Haskins & Sells in San Francisco, is that most taxpayers consolidate your other "must change from assuming all interest is deductible to realizing that almost no consumer loans. interest, except for a loan secured for a house, is deductible." What follows are details on how the loans up to the purchase price of your new tax law will bash borrowers-and house, plus the cost of improvements, how borrowers can bounce back: may be deducted. Also still deductible: Consumer interest. Starting on Jan. I, interest charges on home-equity loans deductions for interest payments on con- used to pay for medical expenses or a sumer debt will be phased out. The sched- child's education. ule specifies that next year, 65% of your The reform rules, though crimping the consumer interest payments will be de- deductibility of interest on home-equity ductible; in 1988, 40%; in 1989, 20%; in loans, which can be as large as 80% of the 1990, 10%; and in 199 1, the write-off will appraised value of your house, still leave vanish altogether. you plenty of borrowing room. For exam- The change will turn smart shoppers ple, if you bought a house for $100,000 into amateur accountants as they try to five years ago, financed $80,000 of it and determine whether paying cash is better have since made $10,000 worth of im- for them than buying on credit. If you are provements and paid down, say, $1,000 considering buying a new car, for exam- of principal, you could deduct the interest ple, you may still be able to come out payments on a home-equity loan of up to ahead by borrowing despite the loss of $31,000. The tax bill would then let you the interest write-off. Say you are in the use that line of credit, say, to buy a car or 28% tax bracket after reform fully takes consolidate debts on which interest pay- effect and borrow $10,000 at 6.9% inter- ments will lose their tax deductibility. est. Over the customary four-year period Margin loans. Under the bill, if you bar- for such a loan. you would pay $1,380 in row on margin from a broker or use a bro- nondeductible interest. But, by not pay- kerage-house line of credit to make an ing cash, you could theoretically invest investment, the interest you pay will be that $10,000. If you put the money in deductible only to the extent that it is off- Treasury bills paying 7%, you would earn set by investment income from such $2,170 after tax over four years, more sources as dividends, capital gains and than compensating you for the interest limited partnerships. If you want to de- payments on the loan. duct$1,000 worth of interest on margin You can get ready for the new math on debt, for example, you must report at consumer credit by paying off, or at least least $1,000 of investment income on paying down. any credit-card balances. If your 1040. What is more, you will no you must carry balances on plastic, you longer be able to write off interest on such can get a list of banks offering cards with debt if you use the money for something finance charges as low as 12% for $1 from other than investments. Currently, you Bankcard Holders of America, a non- can borrow on margin or use a brokerage profit consumer group, 333 Pennsylvania line of credit for any purpose, and the in- Ave. S.W., Washington, D.C. 20003. terest you pay is deductible up to the Home-equity loans. If you own your amount of investment income you report house, you will still be able to use it as a plus $10,000. In the future, you may have versatile financing tool, despite tax re- to provide the IRS with documentation form's new limits on home-equity loans. that you actually used the money to make As of Jan. 1, only mortgage interest on an investment.

92 MONEY 96 MONEY @ 1986 Time Inc. Reproduced by the Library of Congress, Congressional Research Service with permission of copyright claimant. - AFTER REFORM: Savin_(~ Creative Ways to Save for College Some excellent tax-advantaged options will survive, but you will have to be agile to benefit from them.

No more. The not-so-pleasant details: Then his tax rate will apply. But if you set BY ROBIN MlCHELl Clifford trusts. Under the new law, all up the trust after that date, the income income from newly created Cliffords will will be taxed at your rate even after your be taxable to whoever sets up the trust, child hits 14. Best advice: You probably First the bad news. The challenge of whether they be parents, relatives or won't be able to dissolve an existing Clif- building savings to pay for your chil- friends. If you have already established a ford, so if yours beats the March 1 cutoff, dren's education-which was never Clifford, its tax treatment will depend on load it with tax-deferred investments easy-will be even tougher after the re- when you did so. Income from trusts cre- such as U.S. Savings Bonds. If it is newer vised tax law takes effect. Items: ated before March I, 1986 will be taxed at than that, your best option is tax-exempt b Unless you use home-equity loans (see your rate until your child reaches age 14. municipal bonds. u the story on page 91). you will no longer be able to deduct the interest on money you borrow for college. b Your son or daughter will have to pay tax on any scholarship money that doesn't go for tuition and fees. b And your ability to cut taxes by shifting your savings to your child through gifts and trusts will be restricted severely. Some superb tax-advantaged ways to save will remain. But Bruce Scharf, a partner in the Circle Consulting Group, a financial planning firm in New York City, warns: "Parents are going to have to be more creative now." Under the old law, you could transfer investments to your offspring through two principal means: Clifford trusts, in which assets are held in your child's name for 10 years before reverting to you, and custodial accounts established under the Uniform Gifts to Minors Act (UGMA). in which assets are owned by your child I outriat. In both cases, earnings on tho= 1 LrWe'llpr~bablybuy mllni~ipalZWOS in OW I assets were taxed at your child's rate, no I matter what his age, rather than at your I own name. why use trusts anymore?" presumably higher rate, making it easier for you to build funds for school bills. -JOHN DILLOW AND HIS FAMILY OF SEATTLE 1

PHOTOGRAPH BY RICH FRlWMAN OCTOBER 1986 101 8 Custodial accounts. You can still put After reform, all as much as $10,000 a year ($20,000 if you give jointly with your spouse) in earnings on gifts an UGMA account for each child. But only the first $1,000 of income from new made to children and existing accounts will be taxed at your child's rate if he is under 14. On anything above that, your rate applies. Once your child turns 14, however, all will be taxed at the account's earnings will be taxed at his rate. Best advice: make as heavy use the child s rate. of UGMA accounts as you can, bearing in mind your child's age so that you can 18 years a child born this year would have invest the money in ways to keep taxes up to $178,000 to borrow against for col- low. For example, if your child is under lege at below prevailing bank rates. 14 and his account now consists of in- Don't overlook tax-exempt securities. come-oriented stocks, such as utility Yields on them have been extraordinarily shares that have risen since you bought high lately. with 30-year municipals pay- them, sell the stocks before the end of the ing about 7%%,compared with 7%% for year while the capital gains will still be taxable Treasuries of similar maturities. taxed at your child's rate. Then reinvest Zero-coupon municipal bonds are espe- the money in fast-growing companies. cially well suited to college savings plans. When your child reaches 14, you can sell They pay no interest. Instead you buy the shares and any gain will be taxed at them at a deep discount from face value his rate. and receive the full amount when the Put the proceeds in the safest bonds mature. Thus you can count on ac- high-yielding investment you can find, cumulating a specified sum of money by since the interest will no longer be taxed the time you need it. But make sure that at your rate. Current examples of such any zeros you buy can't be redeemed be- investments include high-grade corporate bonds (currently yielding around fore their maturity date by the issuer. Re- 9.5%) and risk-free one-year Treasury cently you could buy a 10-year, $1,000 bonds, paying 5.4%. You should avoid zero municipal yielding 7% for $400. risky investments at this point because One apparent loophole in the new with college only a few years away, you rules on custodial accounts offers an un- may not have enough time to recoup beatable option if you can take advantage losses. of it. Under the revised law as now writ- Another way to postpone taxes while ten, all earnings on gifts made to children you build savings in a young child's ac- by grandparents, other relatives or even count is to buy supersafe Series EE U.S. friends are taxed at the child's rate, no Savings Bonds with maturities that fall af- matter what his age. Such a benefactor ter the child's 14th birthday. The bondsL can give as much as $10,000 a year tax- currently pay at least 7%% annually if free to each of your children. held for a minimum of five years. The Bit don't be hasty about transferring interest won't be taxed until the bond3 money to your folks or Aunt Nellie for mature. them to deposit in your kids' college An alternative tax-deferred invest- kitty. The IRS is expected to be on the ment is life insurance. The policy's cash lookout for such fancy footwork. Barry value will increase over the years with no Salzberg, a partner in the accounting taxes due on the earnings until with- firm of Deloitte Haskins & Sells, advises: drawal. Eventually your child could bor- "The two gifts, from parent to grand- row at low rates from the policy to pay parent and grandparent to child, cannot school bills without owing any tax at all. be remotely simultaneous." If they are. For example, you might pay annual pre- you could have to pay the IRS the differ- miums of $5,100 for a $250,000 universal ence between the taxes owed at your rate life policy that nets, at present, 7%% a and at your child's as well as interest and year. If current rates of return hold, after penalties. 00

102 MONEY 106 MONEY SELECTED PROVISIONS AFFECTING REAZl ESTATE AND HOUSING (~xcerpts): Understandinq the 1986 Tax Changes, Touche, Ross & Co.

Low-Income Housing Credits The 1986 act allows three new tax credits for investors in low-income housing: for construction, acquisition, and rehabilitation of low-income housing. These new credits replace a number of incentives for investment in low-income housing. 1. New construction or rehabilitationof existing housing. A maximum tax credit of 9 percent per year for 10 years for expenditures on new construction or rehabilitation of qualifying low-income housing units not financed with tax- exempt bonds or other federal subsidies. 2. New construction or rehabilitation financed by federal subsidies. A credit of 4 percent a year for 10 years on expenditures for construction or rehabilitation of low-income units financed by tax-exempt bonds or other federal subsidies. 3. Acquisition costs of existing housing. A credit of 4 percent a year for 10 years on the acquisition costs of low-income units. For the first two credits, expenditures must exceed $2,000 per low-income unit. Also, the first two credits can be applied in addition to the third. In other words, if existing housing is acquired for low-income use and it is rehabilitated without federal subsidies, the total annual credit would be 9 percent of the rehabilitation expenditures plus 4 percent of the acquisition costs. These credit percentages will be adjusted to reflect changes in interest rates. Residential rental projects are eligible for the credit if at least 20 percent of the units are occupied by individuals with incomes of 50 percent or less of the area's median income, or if 40 percent of the units are occupied by people with incomes of 60 percent or less of the area median. The rent that can be charged must also be limited. The depreciable basis of property subject to these credits is not reduced by the amount of low-income housing credit claimed. The amount of credit given is limited by a state volume cap. In general, each state is granted rental housing tax credits of $1.25 per state resident. Use of the low-income housing credit is subject to the passive-loss rules described above. Thus the credit may not be available to offset t& other than tax generated by passive income. However, the credit will be available to offset tax on up to $25,000 of ordinary income as long as the taxpayer's AGI is not over $200,000. This treatment phases out for AGI between $200,000 and $250,000. Effective date: Generally, property placed in service after 1986 and before 1990.

Source: Understanding the 1986 Tax Changes; An Executive Summary @I986 Touche, Ross & Co., Inc. pp 3-.'b Rehabilitation Credit Previous law allowed a tax credit for the costs of rehabilitating older buildings. The credit rates were 25 percent for certified historic buildings, 20 percent for buildings more than 40 years old, and 15 percent for buildings more than 30 years old. The 1986 act significantly modifies the rehabilitation credit-to 20 percent for certified historic structures and 10 percent for other buildings placed in service

before 1936. As under previous law, certified historic structures can be residential or nonresidential, but other buildings must be nonresidential. The definition has also been revised for those parts of the original building that must be retained in the rehabilitation. To qualify for the credit, buildings other than certified historic structures must retain at least 75 percent of the existing external walls (50 percent as external walls), and at least 75 percent of the building's internal framework must also be kept. The basis for depreciation of any rehabilitated building is reduced by the full amount of any rehabilitation credit claimed. Effective dare: The modifications in the new law generally apply to buildings placed in service after 1986. Transition rules apply to buildings for which there was a binding contract for rehabilitation or in which rehabilitation had begun before March 1, 1986. Provided the transition requirements are satisfied, credits will be available if the property is placed in service before 1994. There are also special transition rules for many specified buildings and projects. The new law has transition rules for specified buildings and for buildings under certain rehabiita- tion contracts on March 1,1986, that reduce the 20 percent credit to 13 percent and the 15 percent credit to 10 percent.

Real Estate Investment 'Ifusts A real estate investment trust (REIT) is an entity that receives most of its income from passive real estate investments and distributes most of its income annually to shareholders. If numerous conditions are satisfied, the REIT will not be taxed on income distributed to shareholders. The REIT will generally be taxed only on retained and undistributed income. The 1986 act changes the following REIT provisions, which make it easier for entities to qualify for and benefit from that status and imposes a new excise tax for insufficient distributions. To the extent that the actual REIT distribution to shareholders is less than a required amount, a nondeductible 4 percent excise tax is imposed. Ekction as a REIT. An entity is not precluded from electing REIT status solely because it is closely held in its first year. An automatic change of accounting period is granted with the initial election of REIT status. Established corporations that have accumulated earnings and profits must distribute them to elect REIT status. REITs are permitted to hold assets in wholly owned subsidiaries. Income to a REIT from newly invested capital is treated as qualifying income for one year for the REIT qualification tests. REITs may receive rents based on the tenants' net income. Also, REITs can furnish certain services in connection with renting real property without triggering unrelated business income. REIT distribufions. Certain income a REIT accrues but does not receive is not subject to the general REIT distribution requirements if that amount exceeds 5 percent of the REIT's taxable income. The amount of a REIT's cument earnings

Investments and Tax Shelters 35 and profits cannot be less than the REIT's taxable income. REITs can compute their net capital gains without an offset for net operating losses. REITs can also send capital-gain notices to their shareholders with their annual reports instead of separately within 30 days of year-end. The number of sales that a REIT can make without falling under the prohibited-transaction rules has been raised, and REITs will be allowed to make more substantial improvements to buildings than previously. Effective date: Generally, for tax years beginning after 1986.

Mortgage-Backed Securities The 1986 act creates a new tax entity called a real estate mortgage investment conduit (REMIC). A REMIC is an entity formed to hold a fixed pool of mortgages secured by interests in real property. REMICs were created to clarify the treatment of entities that invest in multiple-class, mortgage-backed securities, and it is intended that REMICs will be the only entities to hold this type of investment. A REMIC receives a deduction for all amounts included as income by holders of "regular interests" in the REMIC; it also gets a deduction for amounts distributed to holders of "residual interests" up to the amount of a deemed return. A REMIC may be created in the fonn of a corporation, a partnership, or a trust. All interests in a REMlC are treated as either "regular" or "residual." Regular interests are treated as debt instruments; residual interests are generally treated as stock. If property is transferred to a REMIC in exchange for either regular or residual interests, gain is recognized by the transferor, but loss will not be recognized until the disposition of the interests. Effective date: Tax years beginning after 1986. ,

Extension of At-Risk Rules to Real Estate Since 1976, the tax law has limited the deductions for a loss in certain activities to the amounts for which the taxpayer is at risk. Generally, that amount has been the sum of the cash invested, the value of property contributed, and the debt for which the taxpayer is personally Liable. All real estate activities were exempt from the at-risk rules until now. Real property is still a major exception to the rules. A taxpayer is treated as at risk in a real estate activity to the extent of qualified third-party nonrecourse financing secured by real property used in the activity. In other words, a taxpayer can still be considered at risk in a real estate activity financed with nonrecourse debt, provided the lender is a person or business regularly engaged in the trade or business of lending money. The taxpayer will not be considered at risk if the lender is the person from whom the taxpayer bought the property or a person who receives a fee with respect to the taxpayer's investment in the property. All loans from related parties, however, must be on commercially reasonable terms. Effective dare: Losses attributable to property acquired after 1986. USNEWS & WORLD REPORT, Sept. 15. 1986, PS6

FAMILY FINANCE H A loo~holethat survives Here's how the tax-reform bill's limits on the deduction of interest would affect John and Jane Smith, who want to borrow against the value of What Gongress giveth: their home, now worth $160,000- Price the Smiths paid for home $100,000 Cost of imorovements they made +$10,000 TOG-invested $1 10,000 It wasn't planned that way, but Con- Generally, the maximum loan is equal Amount owed on present mortgage -$80,000 gress's massive tax-reform plan is about to 75 or 80 percent of the home's ap- Remaining unrestricted borrowing to encourage you to put your home praised value, minus whatever is owed power for tax purposes 530,000 deeper in hock. on the first mortgage. So the person in Homeowners by the millions are ex- Blum's example might in fact qualify The Smiths CAN DEDUCT interest on a home- pected to turn to home-equity loans-a for a home-equity loan of $36,250 if the equity loan of- form of second mortgage-to circum- house were valued at $1 15,000. * Up to $30,000 for any purpose vent tax reform's taboos on deductions As it stands, these provisions will Up to $80,000 for tuition for interest paid on credit-card pur- apply even to home-equity loans that Up to $80,000 for medical expenses chases and all other kinds of consumer have already been taken out. If you Whatever it costs to add a room to the house debt. have borrowed more than the home They CANNOT DEDUCT interest on loans of- Under the reform plan expected to cost, plus improvements, your excess be voted into law later this month, de- deductions will be phased out by 199 1. * More than $30,000 to buy cars or boats ductions for consumer interest will To compete for customers seeking More than $30,000 for vacations, furniture and gradually disappear over the next five home-equity credit lines over the next other major consumer expenses years. But the mortgage-interest deduc- few months, many banks will offer low- More than $30,000 for cash for living costs tion will stay alive. As a result, many interest rates and low fees on such homeowners may trim taxes by financ- loans. Buffalo, N.Y.-based Goldome ing vacations, new cars and fur coats Federal Savings Bank, with $60 million with a home-equity loan. If they decide outstanding in Home Equity Line of dipping into it just to save on taxes. to take the loan in the form of a revolv- Credit balances, expects its current di- ing-credit line-and tap the line only "It's very easy to write a loan against rect-mail and advertising campaign to your home," he says. "But it should be when needed-they pay interest only increase home-equity lending by $225 on the portion of the credit used. reserved for strategic purchases. Go too million over the next six months. Gol- far and you may find yourself overex- "Home-equity loans will be the only dome is charging new customers inter- game in town," predicts Bob Trinz, a tended. Before you know it, you've est 2 percentage points above the jeopardized your home." specialist at Prentice-Hall, which pub- bank's prime rate, with an application lishes tax guides. "They could be the Because home-equity credit lines can fee of $250 ($350 in the New York vary significantly from bank to bank, it primary loan product of the metropolitan area). Closing costs, future," agrees Carl Harris, a is important to understand all available which run 2 to 2% percent of the features before signing up. How vice president at People's Bank' in amount of the credit line, will be picked much will you have to pay in Bridgeport, Conn. up by the bank. closing costs? How is the interest Under the new rules, however, the First National Bank of Chicago rate figured, and when are adjust- length to which you can go to mortgage charges rates ranging from 2 percent ments passed on to you? Remem- your house for other purposes will over prime for small loans to prime plus ber, if the rate is tied to the shrink considerably from what it is now. '/i percent for amounts in excess of prime, it will probably change ev- Mortgage interest will be deductible on $25,000. Customers pay a $100 applica- ery time the prime does, no mat- first and second homes only to the extent tion fee and the cost of title insurance ter how high. that the loan does not exceed the original and appraisal but no other closing costs. Ask how paybacks are handled, purchase price of the home-not its Lure of the loan and be sure you will not be charged market value-plus the cost of improve- Tax considerations aside, home-equi- a penalty for early repayment. ments you've made. You can deduct ty credit lines are attractive to borrow- Each time you write a new check more only if the loan's proceeds are used ers for many reasons. Once established, against your credit line at United to pay for education, medical expenses they remain in place for years and can Jersey Bank, N.A., in Princeton, or further home improvements. be tapped at any time by check and for example, your entire balance Room to maneuver sometimes by credit card. While the owed is spread over a new 15-year Even when restricted that way, the rates are almost always variable, they term. At First Chicago, you can provision leaves owners who have had pay what you like each month as time to build up equity plenty of room to tend to be lower than for other kinds of consumer loans. Payback is often flexi- long as you keep up with the inter- maneuver, says Gary Blum, a tax part- est. The whole amount comes due ner with the accounting firm Seidman & ble. Generally, you can pay off the loan early without penalty, and since the after seven years. Seidman. Suppose you bought your As attractive as the terms and home for $100,000 and have since added term of the loan may stretch as long as 15 years, monthly payments can be the tax deductions may be, ex- an air-conditioning system and a new perts say to keep in mind that driveway for $15,000. If your mortgage kept quite low. But such home-secured credit can be loans make sense only if they are is paid down to $50,000, you could used wisely. Fa borrow $65,000 for whatever reason and dangerous. New York City financial adviser Lewis Altfest warns against deduct the interest, by Anne McGrath Banks limit what they will lend against a home, of course. Tax Proposal Trims IRA, 401 (k) Benefits Peruiolu Impmfor Low-hid &ken

@ 1986 The Washington Post Company. Reproduced by the Library of Congress, Congressional Research Service with permission of copyright claiqant. 14 C~t~corpSavmgs of Wash~ngton,D.C. Reproduced by the Library of Congress, Congressional Research Service. A Federal Savings and Loan Associat~on 1775 Pennsylvan~aAvenue. N.W. Wash~ngton,D.C. 20006

A NEWSLETTER FOR INDIVIDUAL RETIREMENT ACCOUNT PARTICIPANTS

TQX REFORM CONFEREES RERCH FINQL RGREEMENT ON IRR PROVISIONS

On Flugust 16, house ar!d Senate conferees resolved legislat ive differences and agr-eeci U~UYIthe Tax Reform Bi 11 of 1'386. The Bi 11 must now be approved by both Houses of Congress and must be signed by the President. Qs we get tcl press, neither t ne House nor Senate has voted on this legrslatiw-I.

Tie Bill clx~tainsprovisions w:'lich will ~r-abablyaffect yc~urIRR. Glnyone under 78-I/? can st i 11 put up to Si28@8 of earned income in an IRc: each year and earn tax-deferred incorfle. But fur millions, the ri ght to pdyyt; ccmtri Dut ions ends.

Whc~ will be eligible for IRQ deductior~sfur the 1'387 tax year? Tax~ayer-snot -cu_v_e-gd by a retirenrent plan at work will st ii 1 be able to deduct IRQ cor~tributions. IRQ deductibility will be based on the f o? lowing criterla for taxpayers who are cpyeypd oy employer-maintained p! ans:

o E_ull.y-d_gd__ucgible, if adjusted gross income is below 848,888 for joint taxpayers and below 825, 8@8for single taxpayers.

o Psrtially,d,ed_u_ctible, if adjusted gross income is between $48,8Q@ and 858,888 for married couples and between $25,888 and 838,888 for singles.

o bJpJ--dedy~&Lbig, for taxoayers with adjusted gross income over $5G?,888 IZBYI a jclir~treturn and over- $39,8@8on a single return. however, these t axoayers wi 11 be ab~eto make non-deduct i ble cor~tri but ions up to $2, 888 a year- where interest can grow tax- defer-rea.

qt-eater ernahasis neeus to be placed on the major benefit of an IRFI - tax-deferred earnings. If you invest 92,888 a year in a taxabie account, earning 8% and pay taxes on the earrllngs at the 28% tax rate, at the end of 28 years yclu* 11 have 875,831. Put those %i?,@U@ deposits in a nun-deduct ible but tax-deferred IRQ ar~dat tne end of that time yc~u'11 have $98,846. If you withdrew it a11 and paid the deferred tax bill on tne ea-ninns, yo^.! wind I with 882,378. The longer you contribute to an IRR - deductible or nut - the greater the advantage uf t ax-deferred earnin~s. find rernern bet-, since ?-ton-ded uct i b 1e contribllt ions a?-e made with after-tax dollars there is no tax liability on your st-irrcinal investment when withdrawn and you can ;flake IRS oenalty-free withdr-awals or-ior to 53-1 /2. 15 To helo yuu better visualize tne proposed IRR eligiblity r-eau ir-ert~ents, a "aecislon tree" is orovided for- ymur reference.

ELIGIBLITY REQUIREMENTS TO DEDUCT IRR CONTRIBUTIONS

1 Do you work and have I earned income?

Not eligible

Rre you under 78-1/2?

- Not eligible

Does your Employer have a Plan for Employees?

You're eligible

Marital Status?

How much do you and How much do you earn? your spouse earn?

Between S25,000 and 935,888 uI 1f iau both YCI'U can YOU Eer&ot You can You car1 ear-n i ncome, par-t ially deduct your par-t i a 1 1y deduct you can deduct deduct your contri but ion deduct your up to UP to $2,088 corttr i but ion contri but ion 8Z81218 each

-- The information contained herein Is believed to be reliable, but its accuracy and completeness cannot be guaranteed. The IRA TIPS Newsletter is distributed with the understanding that the Publisher and contributors are not engaged In rendering legal, accounting, or other professional services. If legal advice or olher profes sional assistance Is required, the services of a competent professional person rhould be sought. (From a Declaration of Principles jointly adopfudby a Committee 01 the American Bar Association and a Committee of Pubiirhrrr.) AFTERREFORM: Benefits Comaanv Benefits Reel from the Zeal of Reform It will be more costly to take money out of company savings plans before you retire, and easier to qualify for a pension.

BY DENISE M. TOPOLNlCKl

As anyone who pays taxes knows, Congress giveth deductions with one hand and taketh them away with the other. Unfortunately, lawmakers were not in a giving mood when they rewrote the sections of the tax code that deal with corporate benefits. Highly paid employees who receive the most generous retirement packages will be hit hardest, but every wage earner will feel reform's lash. Among the many negatives, you won't be able to stash as much cash as you can today in profit-sharing, 401(k) salary- reduction and other tax-deferred savings plans, nor will you be allowed to tap those savings before retirement as readily as you can now. The major plus: the law that will take effect Jan. 1 will trim the time it takes to be fully vested in a pension plan from 10 years to five. Here's a rundown on how to cope with "Judy and I are happy about five-year the new taxes: pension vesting. If I decided to change jobs COMPANY-SPONSORED SAVINGS PUNS The basic rules remain the same: or retire, I'd be able to do it sooner. " Money that you and your employer contribute to profit-sharing, stock- -GORDON CAMPBELL AND HIS WIFE JUDITH OF WYNDMOOR, PA. ownership, 401(k) and other investment accounts grows tax-free until it is with- @ 1986 Time Inc. Reproduced by the Library of Congress, Congressional Research Service with permission of copyright claimant.

17 RKlTOGRAPH BY MARIANNE BARCELLONA OCTOBER 1986 109 Benefits

, appealing, they will remain attractive Since it will cost you a long-term, tax-deferred investments, par- ticularly for people who can't deduct IRA 10% tax penult to contribution-, (see the story on page 63). Says Chris Parsons, a tax partner with the withdraw from a accounting firm of Deloitte Haskins & Sells in Houston: "Since 401(k)s are no 401(k), the money that longer very liquid, the money you're putting into them had better be for long- you put in should be for term retirement purposes. If it is, put in as much as you can before the $7,000 limit I your retirement takes effect on Jan. 1." Conversely, if you anticipate some hardship in the near fu- drawn. You put after-tax dollars in these ture, get your money out of your 401(k) plans except for 401(k)s, which you fund before 1987. with pretax earnings. The new law also changes the income Under both the new and the old rules, tax treatment of withdrawals from tax- your annual contributions to all these ac- deferred savings plans. You will not be counts, plus the money your employer able to pull out just your own contribu- kicks in, may not exceed 25% of your pay tions, which are not taxed. Next year, or $30,000, whichever is less. Currently, each withdrawal must consist of con- only a small portion of your after-tax contributions made by you and your em- tributions are counted against that limit. ployer, as well as some of the account's Starting in 1987, however, all after-tax earnings. Say that lo%, or $3,000, of your dollars that you put in will count toward $30,000 profit-sharing account came the $30,000ceiling, and you won't be able from your own after-tax contributions. If to sock away more than $7,000 a year in a you withdrew $3,000 under the old rules, 401(k). For middle-income taxpayers, you would owe no tax because the money however, these ceilings are rather high. would be a return of your principal. But Perhaps more worrisome, the new law under the new regulations, only 10% of will more tightly restrict withdrawals the withdrawal, or $300, would be con- from a company plan before you retire. sidered a return of principal and escape The most stringent provisions apply to tax, while $2,700 would be subject to tax 40 1(k)s. You are now allowed to take out as well as the 10% early-withdrawal pen- your own contributions, your account's alty. Assuming you were in the top earnings and, in some cases, even your bracket next year, you would wind up employer's contributions, if you retire, with only $1,390.50 after taxes. leave the company, become disabled or But don't rush to raid profit-sharing can prove hardship. And hardship has and other accounts that you have been been loosely interpreted to include buy- funding with after-tax dollars. The provi- ing a house or paying college tuition. sion will not apply to balances you have After tax reform, however, if you plead built up through the end of 1986. They hardship you will be permitted to with- also will escape the tax penalty no matter draw -only your own money from a when you withdraw the money. 401(k), and you will have to pay a 10% In the end, under tax reform, the least tax penalty as well as income tax on the painful way to get cash out of company- sum. The penalty is waived if you use the sponsored savings plans will be to borrow money to pay medical expenses that ex- it. Says Allen Steinberg of Hewitt Asso- ceed 7%% of your adjusted gross income. ciates, a benefits consulting firm in Lin- The new law will also impose a 10% tax colnshire, Ill.: "Congress has stacked the penalty on early withdrawals from profit- deck in favor of borrowing because sharing and other company-sponsored there's no 10% tax penalty on loans." plans to which you contribute after-tax Taking out a loan will become less ap- earnings unless you are using the money pealing, however, because the deduction to pay tax-deductible medical bills. for consumer-loan interest will be phased While restrictions on early withdrawal 3111 (see page 91). Moreover, the legisla- and the $7,000 cap will make 40: (k)s less tors have reduced the maximum amount

110 MONEY

&CERP~ TPX REFORM ALT OF 1986--Conference Report to Accanpany H.R. 3838 (House Report 99-841, 99th Congress;, 2d Session, Sept. 18, 1986)

4. Vesting Standards Present Law In general To ensure that employees with substantial periods of service with

the employer do not lose plan benefits uDon senmation- - - from- - - - em-- - ployme&-the Code requires thk und& a qualified plan

(1) a participant's benefits be fullv vested uwn attainment------of normai retirement age under the dan; (2) a dicipant be fully vested at all times in the benefit derived from em~loveecontribu- tions; and (3) employer-provided benefits vest at l&t k rapidly as under one of three alternative minimum vestine schedules (Code sec. 411(a)). Under these schedules, an employee9~right to be&fib derived from employer contributions becomes nonforfeitable (vested) to varying degrees upon completion of specified periods of service with an employer. Under one of the schedules, full vesting is required upon completion of 10 years of service (no vesting is required before the end of the 10th year). Under a second schedule, vesting begins at 25 percent after completion of 5 years of service and increases gradually to 100 percent after completion of 15 years of service. The third schedule takes both age and service into account, but, in any event, requires 50-percent vesting after 10 years of service, and an additional 10-percent vesting for each additional year of =mice until 100-percent vesting is attained after 15 years of service. Patterna of discrimination Vesting more rapid than under the 3 schedules described above may be required under a qualified plan to prevent di ' ' tion if (1) there has been a pattern of abuse under the plan tending to die- criminate in favor of employees who are officers, shareholde~or highly compensated, or (2) there has been, or there is reaeon to believe there will be, an accrual of benefita or forfeiturea tending to discriminate in favor of employees who are officers, shareholders, or highly compensated (sec. 411(dXl)).

The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) required that for any plan year for which a qualified plan is top , an employee's right to accrued benefits must become nonfor- k%%e under one of two alternative schedules. Under the tittop heavy schedule, a participant who has completed at least 3 years of service with the employer maintaining the plan must have a nonforfeitable right to 100 percent of the accrued benefit derived from employer contributions. A plan eatisfies the second alternative (&year graded vesting! if a participant has a nonforfeitable right to at least 20 percent of the accrued benefit derived from employer contributions at the end of 2 years of service, 40 percent at the end of 3 years of service, 60 percent at the end of 4 years of service, 80 percent at the end of 5 years of service, and 100 percent at the end of 6 years of service with the employer.

Reproduced by the Library of Congress, Congressional Research Service. 20 Special vesting rules also apply to "clam year plans." A class year plan is a profit-sharing, money purchn=e,or stock bonus plan that provides for the separate vesting of employee rights to employer contributions on a year-by-year basis. The minimum vesting requirements are satisfied if the plan provides that a participant's right to amounts derived from employer contributions with respect to any plan year are nonforfeitable not later than the close of the fifth plan year following the plan year for which the contribution was made. Changes in vesting schedule Under present law, if a plan's vesting schedule is modified by plan amendment, the plan will not be qualified unless each participant with no less than 5 years of service is permitted to elect within a reasonable period after the adoption of the amendment to have the nonforfeitable percentage of the participant's accrued benefit computed under the plan without regard to the amendment. Home Bill No provision. Senate Amendment In geneml The Senate amendment provides that a plan is not a qualified plan (except in the case of a multiemployer plan), unless a participant's em loyer-provided benefit vests at least as rapidly as under one of 2 af'ternative minimum vesting schedules. A plan satisfies the first schedule if a participant has a nonforfeitable right to 100 percent of the participant's accrued benefit derived from emplo er contributions upon the participant's comple tion of 5 years ofservice. A plan satisfies the samnd alternative schedule if a participant has a nonforfeitable right to at least 20 percent of the participant's accrued benefit derived from employer contributions after 3 years of service, 40 percent at the end of 4 years of sewice, 60 percent at the end of 5 years of service, 80 percent at the end of 6 years of service, and 100 percent at the end of 7 years of service. Top-heavy plans The provisions of the Senate amendment relating to vesting do not alter the requirements applicable to plans that become top heavy. Thus, a plan that becomes top heavy is required to satisfy one of the two alternative vesting schedules applicable under present law to top-heavy plans. Class-year plans A plan with class year vesting will not meet the qualification standards of the Code unless, under the plan's vesting schedule, a participant's total accrued benefit derived from employer contributions becomes nonforfeitable at least as rapidly as under one of the two alternative vesting schedules specified in the bill. Changes in vesting schedule If a plan's vesting schedule is mded by a plan amendment, the plan will not be qualified unless each participant with at least 3 years of sewice is permitted to elect, within a reasonable period after the adoption of the amendment, to have the nonforfeitbble percentage of the participant's accrued benefit computed without regard to the amendment. Multiemployer plane As an exception to the general vesting requirements, the bill re quires that, in the case of a multiemployer plan, a participant's accrued benefit derived from employer contributions be 100 percent vested no later than upon the participant's completion of 10 years of service. Effective date The provisions of the Senate amendment are generally applicable for plan years beginning after December 31, 1988, to participants who perform at least one hour of service in a plan year to which the new provision applies. A special effective date applies to plans maintained pursuant to a collective bargaining agreement. Under this special rule, in the case of a plan maintained pursuant to a collective bargaining agreement between employee representatives and one or more employers ratified before March 1, 1986, the amendments are not effective for plan years beginning before the earlier of (1) the later of (i) January 1, 1989, or (ii) the date on which the last of the collective bargaining agreements terminates, or (2) January 1, 1991. Ex- tensions or renegotiations of the collective bargaining agreement, if ratified after February 28,1986, are disregarded. Conference Agreement The conference agreement follows the Senate amendment. In addition, the conference agreement modifies the rule permitting an employer to condition participation in a plan on 3 years of service. Under the conference agreement a plan may require, as a condition of participation, that an employee complete a period of service with the employer of no more than two years. A plan that requires that an employee complete more than one year of service as a condition of participation must also provide that each participant in the plan has a nonforfeitable right to 100 percent of the accrued benefit under the plan when the benefit is accrued. In addition, the conference agreement limits the special rule for multiemployer plans to employees covered by a collective bargaining agreement. Also, benefits that become vested due to these provisions are to be immediately guaranteed by the PBGC (without regard to the phase-in rule). The conference agreement also modifies the effective date so that the provision applies to all employees who have one hour of service after the effective date. This revised effective date also a plies to the conference agreement modification regarding years oP service r uired for participation. % addition, the conference agreement limita the delayed effective date for plans maintained pursuant to a collective bargaining agreement to employees covered by such agreements. Variable Annuities, Life Insurance: Tax-Favored Investing-At a Price tirement age is subject to ordinary Income "For the most part. I'm inclined to keep tax on the amount attributable to earnlngs. my clients in mutual funds because of the Withdrawals before age 59% are gener- Ilquidity and the flexlbllity," says Linda J. ally subject to both ordinary Income tax Jepson of Flnanclal Planners Equity Corp. and a penalty, whlch would rlse to 10% In Erie. Pa. from 5% under the tax package. Like variable annuities, variablelife$. By KAREN sum The tax treatment is the key to the insurance policies allow holders to invest in St&ffReporter THE WALL STRICTJOURNAL vestment. "It's a way to accumulate your mutual funds without paying current taxes Wlth tax overhaul a virtual certainty, dollars without current taxes comlng out, on the income. But sellers of varlable life brokers and other financial advisers are which translates into a hlgher return," lnsurance say that the product addresses scrambling to flnd investments that will says Joseph W. Jordan, Insurance-product one of the big drawbacks of varlable annul. have the most allure In the new environ- manager with PaineWebber Inc. ties: the tax bite on withdrawals before re- ment. Among the items getting their atten- Indeed, over a 20-year holdlng period. tirement. VarlableHfe policyholders have tlon: variable annuitles and variable llfe the after-tax return on a variable annulty tax-free access to their funds by borrow- Insurance. can be more than one percentage point ing, often at an interest rate of no more These products, whlch combine mutual- higher than the return on a mutual fund than 1% or 2% a year. fund investing with the tax deferral of in- with the same gross earnings and fees. Variablelife policies also include lifein. surance, are among the blg winners under Mr. Dally of Seidman Flnanclal notes, surance coverage that can be two or more the proposed changes, brokrrage and In- however, that the advantage slips to only times the size of the origlnal Investment. surance executlves say. When marketed principally as Invest- The bill approved by House and Senate Variable Annuities ments, these policies are typically sold on conferees preserves the tax advantages of a slnglepremlum basis. rather than wlth lnsurance while virtually eliminating tax Vs. Mutual Funds annual premlums.) If an insurance poky shelters and curtalllng deductions for Indi! A~urnea20-year holding period, Is in force at death, the pmeeds pass to vidual retlrement accounts. It also eliml- 80% tax rate and 11%annual yield nates the preferentlal rate for capital beneflclarles free of Income tax. before expensea. Compared with a variable annuity, "It galns, making it more attractlve to buy se- EFFECrn curities through a tax-sheltered vehlcle. TYPtCAL AFTER-TAX Is the more flexible product." says Jerome "I fully expect variable annuities and ANNUAL ANNUAL S. Golden, president of Monarch Resources varlable Ilfe to become one of the hottest EXPENSES RETVRN InC., which sells Its variableHfe pollcles products In the financial-services industry primarily through Merrlll Lynch & Co. over the next few years," says Arthur H. Higher Annual Charges Goldberg, presldent of Integrated Re Na-commissian The insurance coverage and the related sources Inc., a New York securities and mutual tuna 1 bamnvtng ablllty of varlable llfe don't real estate firm. Commimioned come free, however. Variable-life policles Unadvertfsed Drawbacks mutual fund 2 have hlgher annual charges than varlable annultles. and thus are a somewhat differ- As with any other hot product, however, Sorm: .?#idman Nm the advantages are tempered by draw- Fi~lCiOl%&m Yd ent product. backs that sellers aren't advertlslng. In the -- - - Variable life "Is a combination of at- case of variable annuitles and variable half a percentage point a year If the annu. tractive Investments and attractive Insur- Hfe, these Include reduced flexlbllity and ity Is compared wlth a mutual fund that ance protectlon," says Donald G. South. fees that lower investment return. doesn't have a sales commission. Annuities well, president of Prudentlal Wfe Insur- "It's not wise to be blinded by the tax- usually are sold wlth sales comrnlsslons- ance Co. of America's variableproducts deferral aspect," says Glenn Daily, Insur- although, as wlth the latest wave of mutual subsldlary. "It certainly Is a better deal If funds sold through brokers and other com- buyers value the Insurance protectlon." anceproduct analyst for the flnanclal plan- mlssloned salespeople, the sales charges ning affiliate of accountants Seldman & are pald out of higher annual fees rather Investors who expect to use the policy- Seldman/BDO In New York. than as an upfront charge. holder-loan option as a tax-free source of The variable annulty, slmpler of the two cash also face a hidden problem, says John products, is essentially a taxdeferred re- "I really don't thlnk the numbers (on H. Cammack, a financial planner wlth Al- tlrement-saving plan. It Is simllar to what the variable annulty) work out to be-as exandra Armstrong Advisors Inc, in Wash- the IRA wIII be Hke after tax overhaul for spectacular as the salespmple wwld like ington, D.C. If they borrow heavily and people who no longer qualify to make a you to believe," Mr. Dally says. thelr Investments perform poorly, they taxdeductlble contribution. Meanwhile, the potentially hlgher re- may need to pay addltlonal premlums to With an annuity, however, there Isn't a turn on the variable annuity needs to be contlnue the pollcy and, hence, preserve maxlmum annual contribution. And if the welghed agalnst other factors. Both the tax the tax-free status of thelr Investments and annulty holder dles during the accumula- burden and surrender charges for cancel- loans. tlon period, the beneficiary Is guaranteed ing the contract In the flrst several years Flnally, in buylng elther a variable an- no less than the amount Invested. make varlable annultles strictly a long- nulty or a variable-Hfe pollcy, Investors The annulty buyer makes one or more term investment. Accordingly, yarlable an- should pay attention to the flnanclal lnvestments Into the contract. The term nuties are most often marketed to, and are strength of the lnsurance company backlng "variable" refers to the fact that the buyer most suitable for, people over 50. the products. The investment dollars are can select and perlodlcally change how the Further, variable annuities usually of- segregated In accounts that are not avail- 'InOney Is allocated among a handful of fer only a handful of mutual-fund choices, able to pay the lnsurance company's other stock, bond and moneymarket funds. In- and thelr performance Isn't llsted In dally Habllltles. But Mlchael Chesman, a vice terest, dlvidends and capital galns accu- newspapers. Investors who like to move prddent and attorney at Prudentlal Insur mulate wlthout any current tax. among funds should also note that they ance, polnts out that the buyer Is dlll rely As with an IRA, money withdrawn In a may be limlted to as few as four switches Ing on the insurer to pay a death benefit lump sum or in annulty payments after re- a year. that exceeds the account balance. Tax Bill Would Change the Rules For Executive Compensation Plans Ry Azirruo~Rmsm many executives won't be willing to risk In Chicago. "If the benefit is unfunded and SW/ Rrpnrtvr nlTnt: WAC.,STREET JOU~MAL the pcssrb~lrty that rates may h~ raised the new owner decldes not to pay. then the In the pilst, some of the most popular again under future administrations. or un- employee is In a very tough position." compensatron and benef~tsprograms for der the pressure of budget deficib. Increased cash or bonus payments. executives have en;lbled them to kep a "Some pwple-especrally the highest. which executives could invest for retire- larger share of their earnmp out of the paid people-may be looking at their low- ment as they like. may thus become a hands of the Internal Revenue Servrce. est tax rates ever." says Richard Raskin. more at!ractlve option. consultanls say. But the proposed new tax law pmmises a consult~ngactuary with Wyatt Co.. a to change the rules for such maneuvers. New York.basPd compensation and benc Savings Placrs The revised code, which was completed fits consulting company. last weekend by a HouseSnate confer. Over the next two years. income de About twothirds of the companies in ence committee and is expected to bwome ferral Is expected to become briefly more the Hay/Hugnns survey offer (Ollkl law by early fall. won't necessarily kill off popular as the lower rates are phased in plans, through which employees canpet the programs. But rompensatlon special- and taxpayers seek to move as much in- aside income in a tax.deferred account ists say it will reduce the appeal of many come as possible from today's 50% rates against retirement. But under the proposed of them. especially for higher.paid execu- into the future. However. Jane Romweber. tax bill. the maximum allowable contnbu. tives. a consultant with Hewitt Associates in Un- tlon drops to $7.000 a year from U0.000. For example, the new bill places signifi- colnshire. Ill.. cautions that the Iymay most seriously afkct~ngexecutives earn- 1100.000 cant restrictions on the USP of soialled be considering taking steps to reduce such ing or more annually. U)l(k) plans for sheltering retirement ~n- short.term income deferral. Furthermore. the bill makes with- come, and sets income ceilings for the de drawals from such funds before retirement ductibility of contributions to individual re Pamkn PLm more difficult- for example. by imposing a tirement accounts. It also sharply limits Under current tax laws, companies can 10% penalty. on top of any income tax the maximum pensron benef~ta company pay out a maximum of L15.000 a year from owed. for early withdrawals. "All the Ipm can pay out of a funded pension plan to an funded pension plans to executives who re posed) restrictions on Ml(k~plans make employee who retires before age 65 Ure at age 55. ?he maximum rises to SO,- them relatively unattractive." says Ever- What's more, the proposed elrmination ett Allen. a vice president of Towen. Per- of special tax treatment for capital gains rin. Fonter & Cmrby. a New York-based will probably curtail the use of a common t OME people- consulting firm. form of stock option. And the lower maxl. especially the highest- For thme parflcipatlng in qualified em- mum rate for personal income taxes is s ployer pension plans, tax deductions on likely to make deferred-compensation paid people-may be contributions to IRAs will begin phasing plans. along with benefits granted in lieu of looking at their lowest tax out at 525.000 annual income for individ- salary. less advantageous. uals and U0.000 for couples. At US.000 an- "For higher-paid people. the attractive- rates ever,' says one nual income for individuals and W).WO for ness of beneflts as tax-effectrve compensa- compensation consultant. couples. no deductions at all are permitted.

Uon is going to lessen." says Michael Car- - - For those without qualified employer pension plans. however. IRA deductions are ter, a senior vice president of Hay/Hug- 000 a year for those who walt until age plns 0..a benefits-consulting group based still allowed. In either case, tnterest can €5. accumulate in the account tax free. In Philadelphia. "We see more executiva The new law. however. sels the maxi- saying. 'Don't bother wth the benefits- mum allowable payout from such plans at just gwe me the cash.' " $72,000 for 62-yearold retires: $60200 for The following are some of the areas in Wyear-olds; and S40.000 for Syearolds. Use of incentive sock options. one of compensation and benefrts that are most The limit would remain at S90.000 for 65 the two main forms of stock options. would affected by the tax bill. year-olds. be preatly reduced under the proposed tax Dtftmd Compcnsatkn Most executivetompensation special- bill. cornpensatlon specialists say. One of Many h~gh.pardexecutives have found ists expect companies to try to make up the major attractions of such benefits- it benef~cial.under current tax laws, to dc the difference for early retirees with pay- that the proceeds have been taxed at capi. fer a ponlon of their Income Into the fu- ments from unfunded penslon plans, wh~ch tal-gams rates-fades wth the elimrnation ture. \Vlth the maxlmum personal tax rate aren't subject to those restnctrons. For of caprtal.ga~ns-taxtreatment. at 507. deferral has meant the ab~lityto companies. however, the disadvantage The Jtatus of nonqualrfied stock op- postpone payment of taxes until after re with unfunded plans is that. wh~leprovls- tions, whme proceeds art- taxed as ordr- tirement-at which trrne, presumably. the Ions for future pension payments must be nary income when the option is exercised. executive would be In a far lower tax charged to income immed~ately, those will remain the same. However. thelr use bracket. 101 916 1r.S. companies polled by mounls aren't tax deductible until pay- Ls comlng under fire as a result of separate Hay/Huggins in an annual survey, about ments are actually made. changes In Financial Accounling Standards one-lhrrd rnd~cated that they had some With unfunded plans used as backup. Board regulat~ons.which will rqurre com- form of defemdcompensat~on plan for the payouts would presumably remain the panies to charge some value for the op. their executrves.r same. But such plans are less secure: Un- lions agalnst the companv's earnlnp state- The new tax rates will change thu. For like funded pnsron plans. unfunded ones ment. Currently. stock options are listed most indivrduals. the maxmum rate wll aren't paranteed by the government. only as shares outstanding. be 28?~{a 3Y; rate rrll apply to taxpayers "With mergers. acquisitions and bank- As a result of both the tax changes and in a cenain hlgh-rncome bracket,. As a re- ruptcles, unfunded liabilities place the pe the FASB regulat~on."I thrnk we'll see a sult. the gap between the taxes that would tential recrpient In the position of berng a lot of rompanies move away from stock be paid immed~atelyand those that mlght credrtor of the corporation." notes Phillp OptiOnS." says Jude R~ch,president of Sib be paid later will be narmwed. ~f not elrml- Hendersnn:%enior vlce prwrdent of A.S. son & Co.. a cornpensatlon consultmg com- nated entirely. hioreover, consultants say. Hansen Inc.! a consulting company based pany bawl in Princeton. NJ. Source: B-E-@Lly_-Rmrt for Executives, Oct. 23, 1986, pp. G9-11

COMPARISON OF CURRENT LAW AND TAX REFORM AaOF 1986 Corporate Taxes

Provirioll New Law

Corporate Tax Rate Graduated up to 46 percent 34 percent top rate. effective July 1. 1987; graduated rata for small business

Ditidends Paid Deduction No deduction allowed No provision

Dhidends Receiwd Dcduction 85 percent Drop from 85 percent to 80 percent over 10 years

Depreciation .4 CRS Five asset classes, ranging from 3 to 19 Current law with 8 asset classes ranging years. using accelerated depreciation from 3 to 3 1.5 years; 200 percent decl~n- schedules ing balance for classes 3. 5. 7. and 10; IS0 percent declining balance for most other property, real estate in 27.5 and 31.5 year classes with straight-line method; no indexing

Expensing Deduction for up to 510.000 annually, unavailable for taxpayers with more than 5200,000 in equipment purchases annually, with addition of anti-abuse rules i In*estmenr Tax Credit 6-10 percent Repealed: 65 percent of carry forwards 3\\0~ed

I i Other tax credits ) Rehobililol~oncredirs 15 and 20 percent credits for non-historic I0 percent for non-historic structures: 20 per- i structures and and 25 percent credit for cent for historic I certified historic structures I Energy credils Alternative energy, production. alcohol fuels. Residential credits cxp~red;busmess credits I and res~dentialcredits for solar. geothermal. oceanthermal ex- ! tended through 1988 I Tmgerrd job1 rredir Up to 53.000 first year, 51,500 second year Extended through 1988 for up to 52.400 first for hiring targeted workers year wages, credit unavailable for second year R& D lox crrdir 25 percent credit for qualified costs (Sunset 20-percent credit: tighten delinition of quali- I 12/31/85) fied costs; new 20-percent credit for corporate donations to university basic research: extended through 1988 / Lw-incum. housing No credit. tax-exempt bond funding and ac- Three new credits for new and old units, celerated amortization election projects using federal subsidies including tax-exempt bonds. and for acquiring units; sunset after 1989

Reproduced by the Library of Congress, Congressional Research Service with permission of copyright claimant.

25 G - 10 (NO. 205) TAXATION AND ACCOUNTING (DER) 10-23-86

COMPARISON OF CURRENT LAW AND TAX REFORM ACT OF 1986 Corporate Taxes

Provisioa Cunemt Lw New lrw

Possessions tax credit Credit for U.S. tax on U.S. possession source Retain credit; tighten active trade or busi- income is permanent ness test and cost-sharing rules 1 Foreign fax credit limits Overall method applies No separate limits for passive, financial. shipping income, and currency gains: impose comparability rules for in lieu of taxes on cross-border loans; with 5 ycar transition rule for cross-border loans to lesser developed countries Orphan drugs credit 50 percent of qualified clinical testing ex- Extended though 1990 penses; expires aher 1987

- - 1 Capital Gains 28 percent preferential rate Preferential rate repealed

Accounting Cash merhod Allowed Generally disallow for taxpayers with over SS million in gross receipts. but exempt -. professionals Production cost No uniform rules Tor multi-year activities Uniform rules requiring capitalization of most costs created for manufacturers and for wholesalers and retailers with more than 5 10 million in gross receipts Cumplered conrracr Alloued I'or long-term contracts Taxpayers must compute 40 percent of contract items under pcrccntage of completion method: the 60 percent of items under the completed contract method covered by new capitalization rules I ~nsto~~n~enrsoles Deferral oi galn allowed Repealed for publiclg traded securities. revolv~ngcredit plans: l~mitedfor other gains based on debt-to-qu~tyratio of taxpayer 1 011 Industry Percenrage deplerion Alloued Current law I~~ronglbledrilling costs Expnse 30 prccnl of ~nlegratedproducers IDCs am- ort~zedover j !cars

Timber 7Special capital gains treatment; amortization Special capital gains rates repealed. but oth- of preproduction costs: special rules. in- er preferential rules generally retained cluding crcd~tfor reforestation

I Financial Institutions I Reserve bad debt deduction Experience method and percentage Repeal only for banks w~thover 5500 million in assets. t~ghtenfor thrift institutions. wtth hpecial exception for troubled banks Deduction for inreresr to carry mx- Allowed Repealed exempts her Operarrng Losses Special 10-year carryback. 5-year Repcaled except for NOLs attributed to bad carryforward dcbts for losses incurred before 1994; NOLs Incurred 1981-1985 get cight ycar carryl'orward

Copyr~ght0 1986 by THE BUREAU OF NATIONAL AFFAIRS. INC.. Wash~ngton.D.C. 20037 26 10-23-86 (DER) TAXATION AND ACCOUNTING (N0.205) G-11

COMPARISON OF CURRENT LAW AND TAX REFORM ACT OF 1986 Corporate Taxes

New Lw

INU~~MCCOIIP.*CI Defirral jw Nfe inruraw and onnuity Allowed Retained income Life insurance reserve deduction Allowed Retained Special li/c insurance deductions Allowed Repealed Tax-exempt status of Blur-Cross. Blue- Allowed Repealed for Blue Cross and Blue Shield Shield: TIAA-CREF only P& C reserve deductions Not discounted Discount reserves; include 20-percent of un- earned premiums as well as a portion of taxuempt bond interat in income Deduction for odditions to protection Allowed Repeal. with current law recapture rula againsr loss accounr

Industrial Development Bod, Volume Cap Sl5O per capita or 5200 million. dropping to 575 per capita or S250 million effective Aug. S 100 per capita after I986 IS, dropping to S5O per capita and Sl5O million in 1988 Bonds nor subject to volume cap 501 (c)(3) bonds. muti-family housing. air- 501(c)(3) bonds. but subject to Sl SO million ports. docks, and wharves. mass commut- institutional cap for non-hospitals, airports, ing facilities, convention centers. and trade dock and wharves, and governmentally show facilities owned solid waste disposal facilities Mortgage Revenue Bonds Separate volume cap. program expires after Included in IDB cap. extended through 1988 1987 Arbit rage restrictions 3-year exception Tighten restrictions

Slinimum Tax Add-on New alternative tax with 2Spercent rate: add preferences. including tax-exempt bond interest, FSC income. dealer installment reporting. capital construction funds. SO percent of book income (switches to earnings and profits in 1990)

Set Operating Losses 1976 rules have never taken effect Replace 1976 rules with provision for stock purchases. tax-free reorganizations: allow prent firm to absorb NOLs at rate based on long-term tax-exempt bond rate

Cemral Utilities Doctrine So gain recognized at corporate level on li- Repealed for distributions and sales complet- quidating sales and distributions of appre- ed after Jan. 1. 1987; grandfather transac- ciated property tions that received transition relief under House bill as long as completed before Jan. 1, 1988

- - End of Section G - -

27 How the New Law Affects Corporations

8 The maximum corporate tax rate goes down from 46 percent to 34 percent. m A corporation's ability to carry forward net operating losses and tax credits is limited when more than 50 percent of the stock changes hands. The deduction for dividends received by one corporation from another corporation is reduced from 85 percent to 80 percent. 8 The basis of stock held by a corporation for less than two years is reduced by the untaxed portion of any extraordinary dividends. Gain will be recognized both at the corporate and the shareholder level on distributions under plans of complete liquidations and on stock sales treated as asset sales pursuant to plans of cemplete liquidation. The technical corrections in the new law are highly technical, but they are not mere corrections. By electing S corporation status, you can take advantage of the lower individual tax rates, avoid two levels of tax on the sale or disposition of the corporation's assets, and avoid application of the alternative minimum tax.

Rates The new law reduces marginal tax rates for corporations. It also simplifies the graduated rate structure, reducing the number of brackets from five to three. Here are the new brackets and rates. Taxable Income ?g, Rate $50,000 or less $50,000-$75,000 More than $75,000 An additional 5 percent tax is imposed on income between $100,000 and $335,000, which in effect creates a flat tax rate of 34 percent for corporations with taxable income of $335,000 or more, and a 39 percent effective rate or! taxable income in the $100.000 to $335.000 phaseout range. Effective dare: July 1,1987. Income in any taxable year that includes July 1, 1987, is subject to blended rates (40 percent maximum for a calendar-year corporation).

The alternative 28 percent tax rate on corporate net capital gains is repealed. Capital gains will be taxed at regular corporate rates. For taxable years subject to the blended rate, the maximum tax on capital gains is 34 percent. The capital-loss pmvisions remain unchanged. Effective date: 'Itur years beginning after 1986.

Source: Understanding the 1986 Tax Changes; An Executive Summary Touche, Ross & Co., pp.6-14

01986 Touche, Ross & Co., Inc. Reproduced by the Library of Congress, Congressional Research Service with permission of the copyright claimant. Dividends and Redemptions Dividends-received deduction. The 85 percent dividends-received deduction drops to 80 percent, and 80 percent is substituted wherever the 85 percent test was previously used. However, the tax on dividends received by a corporation drops from the current 6.9 percent (15 percent times the top 46 percent rate) to 6.8 percent (20 percent x 34 percent). However, dividends received by calendar-year corporations in 1987 will be subject to an 8 percent tax (20 percent times the 40 percent blended rate); and fiscal-year corporations could pay as much as 9.2 percent if their years end no later than June 30,1987, and they receive dividend income between January 1and the end of their year. Effective date: Dividends received after 1986. Extnwnlinary dividends. A corporation must now hold stock for at least two years or its basis will be decreased at disposition by the untaxed portion of extraordinary dividends. Effective date: For dividends declared after July 18, 1986. . An extraordinary dividend is a dividend that is 5 percent or more of the taxpayer's adjusted basis in the stock on preferred stock or 10 percent or more on common stock. The taxpayer may elect to determine whether the dividend is extraordinary by reference to fair market value (FMV) rather than to adjusted basis, if the FMV can be established to the Treasury Department's satisfaction. Effective date: For dividends declared after enactment. Stock-rcdcmpfion expenses. No deduction is allowed for any amount paid or incurred by a corporation in connection with the redemption of its stock. This applies to any corporate redemption and is not limited to hostile takeovers. However, it does not apply to deductible interest, to the dividends-paid deduction, or to other items currently deductible by mutual funds. Effective date: Amounts paid after February 28, 1986. Limitation on NOLs If over a three-year period more than 50 percent of a corporation's stock changes hands, an annual limitation is imposed on the use of the corporation's net- operating-loss (NOL) canyovers. The limitation is calculated by multiplying the loss corporation's value at the time of the ownership change by the long-term federal tax-exempt rate, which will be published monthly by the lkasury Depart- ment. The NOLs eliminated if the loss corporation'fails to meet the present continuity-of-business-enterprise- requirements in the two-year period following the shift in ownership. The restrictions on NOLs apply to built-in losses, exclud-

ing built-in depreciation deductions; but relief is provided to the extent of built-in gains recognized during the first five years following the ownership change. A & minimis rule applies when net built-in losses do not exceed 25 percent of the loss corporation's value immediately before the ownership change. Exampk. Assume that the shareholders of XYZ Corporation sell 51 percent of the corporation's stock in 1987. At the time of the sale, the corporation has $5 million of NOL carryovers, but the corporation itself is worth only $1 million. At the time of the sale, the long-term federal tax-exempt rate is 6 percent. Under the new limitations, only $60,000 (6 percent x $1 million) may be used each year. Since the maximum carryover period for an NOL is 15 years, no more than a total of $900,000 (15 x $60.000) can be used. Consequently, at least $4,100,000 of NOLs will be lost. Furthermore. this loss of NOLs does not take into account the time value of NOLs not available until future years, despite the presence of substantial ongoing income. Creditors are treated as continuing shareholders under this rule if they receive their shares as part of a bc$rnicnr.ptcypmxeding and if they have held their debt for at least 18 months before thif.,bdmptcy filing. Interest on the debt of these creditors is eliminated from the NOL if it was deducted in the three years preceding the bankruptcy filing. The NOb are further cut bacr by 50 percent of the excess of the discharged debt over the value of he stock received. If one-third or more of a loss corporation's assets consists of passive assets, then the income to which the NOES can appkj is subject to reduction, except for regulated investment companies and red estate investment trusts. The value of a iass corporadon is diminished by capital contributions made within two years of the iicquisitmn 6-rl:e if the motive of these contributions was to avoid taxes. The special 10-year carryback rule for financial institutions is repealed after 1986, except for the portion of conmercid bank losses attributable to pre-1994 bad debts. An additional thPee-year carryforward is allowed for thrift institutions for losses incurred after 1981 imd before 1985. Thereafter, they will be. subject to normal carryback and cmyfowwd mies. Caveat: Wlethe skve discussion is framed in the context of NOLs, it applies equally to limiting or eliminatirig any other carryovers (capital losses, foreign tax, investment tax credits, adso forth) from the loss company. Efectiw dare: For pwchases after 1986 md reorganizations with plans adopted after 1986. Connaissecrs of ikis subjxt will be happy to know that the NOL rules that were to be effe'ectiw in I985 are repealed retroactively to January 1, 1986. Thus, the 1985 ales continue in effect though 1986, with certain exceptions.

After over half a century, the i38S act repeals the Supreme Court's General Utilities doct~ne.The new mles require a corporation to recognize a gain or loss on a liquidating distribution as if the corporation had sold its assets to the distributee shareholders at fair market value. Gain or loss will also be recognized by a corporation on liquidating sales. change affects complete liquidations, one-month liquidations, liquidating sales of proprty within 12 months, and stock purchases treated as asset purchases; or in other words, Section 331, 333, 336, 337, and 338 transactions. A filrther change affects the conversion of C corporations into S corporations after 1986. Previous!y, a corporate-level tax was imposed on gain from sales or distributions within three years after the date on which the S conversion took effect. T?re act extends from three years to 10 years the period during which a corporate-level tax is imposed on gains accrued before the conversion. Effective date: For S elections after 1986. Nonrecognition will still be available in complete liquidations of subsidiaries into their 80 percent or mom corporate parents (but distributions to minority interests will trigger grain unless the liquidation is part of a merger). Nonrecogni- tion will also be available in actual and deemed liquidations if more than 50 percent of the corporation's stock hm ken held by 10 or fewer individual shareholders (using attribution rules) for a suhrtaniial time, and if the FMV of the corporation's assets is $5 million or lestr. Relief 'rsr smdi,closely held corporations phases out if their FMVs are between S5 million and $10 million, and this relief is available only through December 31, 1988. In addition, eloslely held corporations under $10 million in value may avoid the 10-year S cnrpration rule if they elect S corporation status before 1989. Wior Iaw contained exceptions to gain-recognition by corporations making certain nonliqiridating distributions. The act repeals all of these exceptions with a transition rule fw amdl closely held corporations. The recapture, tax-ke~efit.and ether statutory and judicial rules continue to apply to these excepred i:ar.rations. In addition, gain will be recognized on ordinary income adshort-tens capita!-gdn property for liquidating distributions. Effective date: kiqnidaiirag d:sributims or sales and exchanges of stock completed after 1986. Example. Several investors form a corporation to buy properties that have the potential for long-term appreciation. For simplicity, assume that these are nondepreciable properties, such as land, stocks, stamps, rare coins, or diamonds. After several years, the assets appreciate by $1 million, and the investors decide .to sell everything and liquidate the corporation. Under the old law, the corporation would not recognize any gain on the appreciation, regardless of whether the properties were distributed to the shareholders and sold by them, or the corporation sold the pt~perties and distributed the proceeds in liquidation. But if the shareholders were in the highest marginal tax bracket,. they would pay capital-gains tax of $200,000 (20 percent x $1 million).

Under the new law, the General Utilities doctrine is repealed, the corporate capital-gains rate goes up to 34 percent, and the individual capital-gainsrate goes up to 28 percent. Liquidation of the corporation will trigger a corporate-level tax of $340,000 on the $1 million gain. When the remaining after-tax gain of $660,000 is distributed to the shareholders, they will pay a 28 percent capital-gains tax of $184.800. Thus, the total tax paid on the liquidation will be $524,800, and the shareholders' after-tax proceeds will only be $475.200, rather than the $800,000 under the old law. Example. XY Z Corporation, a calendar-year taxpayer, has been planning a complete liquidation for the past eight months. The liquidation is to be completed in February 1987. In August 1986, XYZ entered into a letter of intent to sell all its assets to PQR Corporation for $17 million in cash and $12 million in notes. The proposed sale and plan of liquidation must be approved by XYZ's shareholders. If at all possible, XYZ shoiild complete the liquidation in 1986 to obtain the benefits of the General Utilities doctrine before its repeal. XYZ Corporation Balance !Sheet August 31,1986 000s Omitted Recaptun Basis FMV Income Gain Assets: Cash $1,000 $ 1,000 Accounts receivable 1.m 1.m Property, plant, and equipment 2,000s 15,000 $ 8,000 $5,000 Inventory: ---2,000'' 12,000 8,000 2,000 Total =-$6,000 --=$29,000 $16,000 $7,000 Liabilities and Shareholder Equity: Cumnt liabilities $ 500 Long-term debt 2,000 Paid-in capital 2,000 Retained earnings 1,500 Total $6,000

W0.000 less depreciation of $8,000. bS1O,OOO less LIFO reserve of $8,000. In comparing the results of liquidating XYZ in 1986, 1987, or 1988, we assume the shareholders will elect out of the installment method. (000s omitted) Corporation ---1986 1987 1988 Recapture income $16,000 $16,000 $16,000 Recognized gain on sale ---7,000 7,000 Total $16,000 $23,000 $23,000 Tax rate ---46% 40% 34% Tax to corporation $ 7,360 $ 9.200 $ 7,820 Payment of debts ---2,500 2,500 2,500 Cash used for debts and taxes ---$ 9,860 $11,700 $10,320 Cash to shareholders (from $17 million available) ---$ 7,140 $ 5,3& $ 6,680 Shareholders kable distribution: cash (from above) plus $12 million in notes $19,140 $17.300 $18,680 Tar rate ---20% 28% 33%* Tax ---$ 3,828 $ 4,844 $ 6,164 Net cash (cash distribution less tax) $ 3,312 $ 456 $ 516 Notes ---12,000 12.000 12,000 Net distribution ---$15,312 $12,456 $12,516 *At the 28percent rate, the tax would be $5,230 and the net distribution $13,450. Thus, the shareholders would gain $2.856 million ($15,312 - $12,456) by having XYZ liquidate in 1986 rather than in 1987 (an additional 23 percent). The 1988 result does not differ significantly from 1987. mansition rules. In addition to the rule for small, closely held companies noted above, and to liquidations, sales, and exchanges completed before 1987, two other transactions will be grandfathered. One is a distribution pursuant to either a plan of liquidation or a sale or exchange under a binding contract or letter of intent adopted or entered into before November 20, 1985. But the distribution or sale must be completed before 1988. The other grandfathered transaction is an actual or deemed liquidation under a plan of liquidation or binding contract that was adopted or entered into before August 1, 1986. Again, the liquidation must be completed before 1988. lkhnical Corrections The technical corrections in the 1986 act are highly technical, but they arenot mere corrections. Here are some of the major'changes.

Tax-free liquidations of subsidiaries. The stock ownership requirements for the tax-free liquidation of an 80 percentror-more-owned subsidiary into its parent corporation are changed to conform with the consolidated return, affiliated-group stock ownership requirements of 80 percent of both voting power and value. The requirement that the parent own 80 percent of each class of nonvoting stock is eliminated. Effective date: Plans of liquidation adopted after March 28. 1985. Reorganization changes. The transferor corporation in a tax-free reorganization will no longer recognize gain or loss on the receipt of nonqualifying consideration, regardless of whether the properties received are distributed under the reorganization plan. However, gain will be recognized on such nonqualifying distribution of appreciated property under a reorganization plan by the appropriate corporation that is a party to the reorganization. The gain is determined under the same provision that applies to gain on dividends and other distributions. The act also provides that any property, qualifying or nonqualifying, received by the transferor corporation will have a basis equal to its fair market value. In the case of a solely-for-voting-stock asset acquisition, the sale or other disposition of the stock of the acquiring corporation (or its parent corporation) in the reorganization will not produce gain or loss; and the distribution requirement will be satisfied when distributions are made to creditors, as well as shareholders, of the transferor corporation. The act strengthens the IRS's ability to attack liquidation-reincorporation cases by extending the "drop-dowri" of the stock-or-asset provision to acquisitive D reorganizations. So a sale or transfer of assets from the shareholders or fmm the liquidating corporation to a first- or second-tier subsidiary of a corporation in which the shareholders of a liquidating corporation own 50 percent or more of the stock could be treated as a liquidation-reincorporation. As a result, the shareholders of the liquidating corporation, instead of receiving capital-gain treatment, would be treated as exchanging shares in areorganization, and any boot (nonqualifying consideration) received would be taxed as a dividend. Effective date: Reorganization plans adopted on or after date of enactment.

1 Other Changes Discharge of indebtedness. The election allowing solvent taxpayers to reduce the basis of depreciable property rather than currently recognizing income from discharge of indebtedness is repealed. EffPctive date: Discharge of indebtedness occurring after 1986. Extension of the residual allocation method to the purchase of assets. The 1986 act extends the residual method of allocating the purchase price in stock acquisitions treated as asset acquisitions to asset purchases generally. Under this method, both buyer and seller must first allocate the purchase price to the specific assets, up to each asset's FMV. Any remaining, unallocated purchase price is then assigned to goodwill and going-concern value.

Effective date: For transactions after May 6, 1986, unless a binding contract is in effect on that date and at all times after. Personal holding companies (PHCs). Under the 1986 act, certain royalties relating to computer software will not be considered as PHC income. To qualify for this treatment, the recipient of the royalties must (1) be actively engaged in the business of developing computer software, (2) have the royalties make up at least 50 percent of its gross income, (3) incur substantial research or business expenses, and (4) distribute most of its passive income other than software royalties. Effective date: Retroactive to royalties received while the statute of limitations is still open. Regulated investment companies (mutualfunds). While not requiring regulated investment companies (RICs) to adopt a calendar year, the act imposes a 4 percent nondeductible excise tax on the excess of the required distribution over the dividends paid for the calendar year ending within the RIC's taxable year. Effective date: The excise tax applies to dividends paid in calendar years beginning after 1986. The definition of permitted income for RICs is expanded to include income from foreign currencies, and options to futures contracts, derived from the RIC's business of investing. Further, if a RIC has a series of funds, each fund is treated as a separate corporation. In this instance, each fund will be considered to have been incorpo- rated tax-free. Effective date: These two changes applyto tax years beginning after 1986. Planning Ideas 1. Where possible, postpone receiving income until taxable years beginning after June 30. 1987. to take advantage of the lower corporate rates. 2. Take advantage of the alternative 28 percent capital-gains tax rate before its repeal after 1986 by selling appreciated assets before 1987. 3. Complete all stock purchases and reorganizations involving corporations that have NOL carryforwards before 1987 to benefit from the reinstatement of the old law thugh 1986. 4. Complete liquidations and sales or exchanges before 1987 before the repeal of the General Utilities doctrine takes effect. 5. Consider electing S corporation status in 1986 for next year to avoid the 10-year rule (discussed above under General Utilities) or, alternatively, for years beginning in 1986. This way, you can take advantage of the lower individual tax rates, avoid two levels of tax on the sale or disposition of the corporation's assets. and avoid application of the corporate alternative minimum tax (see Chapter 4). 6. Merge a C corporation into an existing S corporation by December 31. 1986, having the S corporation survive. .

7. Complete all planned redemptions during 1986, so that shareholders can benefit from the 20 percent maximum capital-gains tax rate. 8. Individuals holding installment notes received in previous redemp tions, liquidations, or other capital-gain transactions should consider disposing of these notes in 1986 to accelerate the gain so that it will be taxed at the 20 percent capital-gains rate. Corporations that issued installment notes at high interest rates should consider refinancing or prepaying them so the noteholders can accelerate the income. THE \\'ALL STREET JOL'RML TVESDAY. AL'GL'ST 19. 1986 7 > Small-BusinessConferees Voice : Worries About Impact of Overhaul

BY SKWW L J~ms Impact on Small Businesr Sa.fJRrpnerofT,w WluS~mrrr Jour**L #IweC WASHINGTON-The taxoverhaul bill wt-1ar nth $mall.buslnw pple m Elimination- of- invatmmt tu endit ~s~cniblbdIn thr caprtal th~sweek for the Wh~teHow Conference on Small Bwv aar The blll mld elrm~natea number of burlncu tax benrfrts and would add some accounting rrqulremenu thdl many small. compny ownn belleve nll bc a hraner &n ti0 million of annual rror burdcn for them than fnr b~gcorporattons. naipm) '7hr Increases are going to hrt small Mr. Elimination of"Gennl Utilitid sm harder." saM Steve Scllen, a dele doctrim which dlowd r flnn to h pu to the conference and owner of allen liquidrtod with minimal W Advenislng Co.. Dallu. 'fhcre's no way we un pur on the (DIIYP- added Ux hawour business h so corn pcr~ve."rud Stun Grossman. owner of Srm DstnbuUnr Co.. a candy and tobacco wholesaler in Likville. KY.. atid a confer. race ddrpte. Tax ReUef Drrprte the wmrally mgatlve remarks beard about the MI1 rt the conference hrre. Ux speclalists note that It contains me mlid for mesmall companies. W1 there wid be flnanclrl nuoac lbOY thrt don't Invest much In drum md wmr ux benefifs for tbe business etrble uscu wn't be hun by the k& of mmcr and hls hmilv to om the ca- tk Investmrnt Ux credlt or the la-rener. pany's real mate. said Robe!? Mllburn. r m~ de~reclationrchdules. and will rain (PX pnner at the accountlnr !Inn d Ir- hwn Uir rate reductron. nrd Abe Schnkr. venthol k HowaIh. Hrsald an rdvmtyc UX COWLV~at the NatlQlPl Fdrratron of "h Lhat you can dwpav of It nlbout luv- ~ngto pay corporate ~x." &IS." MI. Sctuwler sa~. taut 655 of Benefit for hmlly Members NFIB's more thn =.OM memben rewn A common pncucr In ebvly bcld u emlw of kss thrn 115.000 a year. UII chins k for funtly mrmben to a lkng rtch cuttlnc tbe top corporate real mte pinmnhlps tbrt an nan nu to 34%. tbe Ux bill would eontlnue to md lease them to lhc corpwrtbn. C. Uin. abm even her ntes for small burl- -. LMomc of u much u 130.000 Wdbe Uxed at 151. md Imebt hem m.0~1and m.m m~dbe uxrd rt for hmllv mcmben who irm't emdmd I D'lr rate. The top corporate rate would apply to Incomes ibovr $75.000. Sdlcompania with relatrvely higher revenuer would m hlt by vveral VroViS- Uwmwhv. ' ~arrin tbe ~UI.kcr ~nventorymciununc Tougher rules on sharing pmrta3 bmc rukr. rpplrd tocompan~esnth mom than no miliion of mad receipu, would require keeplnc mck of Inventory-related ems such u DIYIVIIemnvr for em- pbyra who or&< nock ind mantun In- pud s5.m to hrve hLr compnY'S nan- rentoned lum and ochcr expws that men[ ~lanmtm. "la r mull Bnn. O.. bunnoa hrve bcm deduculu u thcy were paid. Under the proposed hw. such eons muld brve to be crp~ulizrdmd wrinen r(l u Inventory h wid. -1t's r whole new ball pme U you ur a rruiler or rholr nler." Pid Stephen R. Cornck. r partner . Pannershlps, proprktonhlp ud Sub tn tbe Wuhlnglon offrce of the accounting chapter S mrporatlarr. vhov Wohtr ud Brm of Anhur Anderun k Co. But the new )ostjlrI?~rdt~theOWWnaSpa~ rules crld apply only to krrrncrvs nth mnmuxrd.mld befomdontoalm mul recelpu excredlng $10 mlllion &wear rccountlnc for ux avmcr un- r war. der -the new law &ten. busin& PU 1 That won't exempt Mr. Cmrrman's dls flrcai year wh~lrLhc menrewn Lromc tnbum Rrm. "It nll mean J lot more pa. on a calendar year. and thus have the w pmrk and expnse." uld hs nfe. of the profm for a tlmr before (&r are Phylls. Uxrd. ~lmpllfledRules Caprul Gains A bmflt for small companlu w~thIn- Sext year, capital pins would br laxrd rmtanu.-...... nil come lmstmul~f~ed rules at ?firr. maklne ~t advant~p~a~~to take for vnnl Iastm. frntout lnrrnlory repon. prns ths yearih~le the nit s %. And he. UFO tends to knp tam lower m m. In some states there nll be ugmhcrntly ni~mryprlOdS Lhan the Hnt-In. hnt. maurnale tax due on crplul ~IMnn out. or FIFO, method. Many small carnap- year hawof Ihr mterplay bawun m. bowever, w FIFO brcaw the ace state lax xhdules and tbe c- la the counting m*hods that the tu code re- frdrnl rula. Mr. Mlbum wid. "You can qulred lor UMwere tmcortly. "We thmk end up owrng natc tu m 100Ct d the tlw nll help mull rela~lenand whole proflt." hr md. Under cumnt lav. u nkn." Mr. Schnerer urd. much as W, 01 a caprtal earn IS freed ux The btll ends tbe tax beneflts a burlnrrr In a number of states owner could ntn by ~IY)owntnt? the flnn's bu~ldlnlrad then irasrnl the propny la Cuhing out of a small bulncsr nth r pontb* tbe tbe company. TM hc mlnctw on se mlnlmal m.x bur has been if Iquldat~oncompl~ed vlth rub called "pur~vekrur" WII bar wntlng off the rocalled General Utilltm doctrine. the papr locvs Irom such an amnlc the pmpowd Irw wwid phw an Uu ad. mcnt awlnst thr mr's=taw. The new btll would allow krvs from lurrrn Invrsr vrntagrars pmcrdure. mrnu such as nal rzlalr to be vnllen off Overall. thr ux blll "Is no IF.l only aptnst parrlvr Imomr. whld! doesn't kr small burrnrr." sa~dCtnld G. Par. tnclude lncomr from wnfoho tnv-nu uy. a pnmr In the WlSlUnFOn UIdf~~ d Pelt. MaWKk. h!ltChrll k a. Tax Overhaul Would Kill Popular Tactic, Mean Higher Bill for Many Professionals to the corporation's undistributed net computations and estimate the tax in order profit, at the corporation's fiscal year- to file for the extension." MONEY end-after the end of the calendar year on The bill does provide an exception for which their personal taxes are based. firms that can show a convincing "busi- Individuals with personal-service corpo- ness purpose" for a different tax year. IRS By MARTHABRANNIGAN rations will be hit hardest by the elimina- regulations say that a highly seasonal busi- Staff Reporter of THEWALL STREET JOURNAL tion of such maneuvers, says Stanley L ness may have "a natural business year," A favorite taxdeferral device of doc- Blend, a San Antonio. Texas, tax lawyer. ending after business hits its high point. A tors, lawyers and other professionals is be- That's because partners and employee- retailer, for example, who makes most of ing wiped out by the new tax bill. owners of S corporations will be able to his sales over Christmas and New Year's spread the extra taxable income over four could seek a year ending just after then. "This is the grinch that stole years. But those with regular corporations One acid test the agency uses to de- Christmas," says Harold I. Apolinsky, a will have to recognize all of it in one year termine a "natural business year" for an S Birmingham, Ala.. tax lawyer and vice and will thus wind up paying at a higher corporation is that if a company gets 25% president of the Small Business Council of rate. America, a trade group. "Congress just m- of Its gross receipts within two months, its ined Christmas" for professionals. Mr. Blend gives the example of a law- year ends after that. yer with a corporation that uses a fiscal The change affects professionals who Gary W. Dix, a Miami accountant, says year ending on Jan. 31. The lawyer pays some of his clients-doctors and other pro- structure their practices as partnerships, himself a salary of 57.000 a month plus a S corporations or regular personal-service fessionals-can make a case for a non-cal- fiscal year-end bonus of $174,000, for a total endar year, because of southern Florida's corporations-the most popular vehicles gross income of $258.000. for professional practices. Under current tourist season. "We're certainly going to law, these people can postpone taxes on Under the pending legislation. Mr. try for it where we think It applies," he some of their income by putting the busi- Blend continues, the lawyer would have to says. Some other accountants and la~yers ness entity on a fiscal year different from include an additional 11 months of per- say, however, that they doubt the II2.S will the calendar year they use to figure their be sympathetic. personal taxes; the income they realize be- Some accounting firms assert that between the end of the fiscal year and the t T ALL boils down ta cause most of their work is bunched into end of the calendar year isn't taxed for an- timing,' says the the first few months of the year, they de- other year. 1 serve to pick a year ending sometime after But under the plan approved by cod- president of a tax- April 15, when workloads peak. gressional tax conferees, both the business accounting firm. 'The "I can't think of a more unnatural busi- and the individual will, in most cases, have government is going to get ness year end for us than Dec. 31." says to use the same tax year. Although there is Gerald W. Padwe, national director of tax an exception for professionals who can the money sooner.' practice for Touche Ross & Co.. whose demonstrate sound business reasons for - year ends Aug. 31. "We don't want to be books not having the years coincide, few are ex- sonal-servicecorporationincome-Sl52.500- closing our and worrying about in- pected to qualify. The change takes effect in his gross income. At the 38.570 transi- ternal things then. That's our heavy client in fiscal years beginning after Dec. 31. tional top tax rate provided in the bill, that time." Raising S 1.7 Billion would mean an added tax of 158.712. But if Waiting to BU Congress estimates that the switch. the lawyer had a partnership instead of a As firms switch to a calendar year. along with a separate, minor deferral-kill- regular corporation, the additional tax- owners must decide how to handle the ing provision, will raise roughly $1.7 billion paid over four years at rates declining "short year" or "stub year" as part of over the next five years. In the short run. from 38.5% to 28%-would total W.304. their overall tax planning. They may want the vast majority of professionals are ex- Mr. Blend says. to accelerate or defer income or expenses pected to face higher tax bills. 'A Horrible Nightmare' during that period. Firms using cash-basis "It all boils down to timing," says Stu- No one is more peeved about the accounting, for example, can reduce their art Becker, president of Stuart Becker & change than accountants and tax lawyers. income by not billing clients until the next Co.. a New York tax-accounting firm. "The They not only have to pay extra taxes, but tax year. government is going to get the money also face highly concentrated workloads as "It will depend on individual circum- sooner." many of their clients are forced onto a cab stances," says Mr. Becker. "If you're The maneuvers that the tax bill elimi- endar year. "It will be a horrible nlght- over-sheltered or have too many deduc- Is tions, you may want to accelerate income nates are complicated, but the principle mare." says Morton Harris, chairman of into that short year." Alternately, an Indi- simple: deferring taxes by exploiting the the Small Business Council's legislative vldual may wish to accelerate deductions gap between fiscal and calendar years. committee. "This will concentrate work and postpone income "to push it off until For instance. if a professional partner- for accountants, tax attorneys, anybody the rates are lower." he says. ship's fiscal year ended Sept. 30. 1985. the meeting with clients at the end of their fis- Those with regular personal-service partner's personal tax return for calendar cal year." corporations may want to make them S 1985 didn't have to show income earned by Many accountants predict the switch corporations to spread the extra taxable the partnership after Sept. 30; that would will be just as painful for the Internal Rev- income over four years, says Jerald D. Au- be included in the return for 1986. The enue Service, which also faces a more con- gust, a Palm Beach, Fla., tax attorney. same applies for an S corporation, a "pass- centrated workload. These accountants ex- "The tax bill is creating a lot of god through" entity that, like a partnership, pect a lot of requests for extensions. reasons for wanting to go S corporation doesn't pay tax at the firm's level. That "won't help us much," however, during 1987," Mr. August says, noting With personal-service corporations, em- says Thomas P. Ochsenschlager, a partner maximum individual tax rates will be ployee-owners have been able to defer in- in the Washington office of the accounting lower than the maxi urn corporate rates. come bypay~ngthemselves a bonus, egual firm Gr-lnt Thornton. "We've got to do the "vs is one more.'Y